accounting lecture

7/27/2019 accounting Lecture

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BAO6504Accounting for Management

Lecture 9

Budgeting

Incremental Analysis

Reference: Chapters 17 & 18


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BUDGETING BASICS

Abudget is a formal written statement ofmanagements plan for specified future time

period, expressed in financial terms The budget is used as a basis for:

Controlling operations

Evaluating performance

A budget promotes efficiency and serves todeter waste and inefficiency


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Budgeting and accounting

Accounting is used to expressbudgetary goals in financial terms

Budgets use historical data onrevenues, costs and expenses

Periodic budget reports are prepared

which management uses to compareactual results with planned objectives


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Benefits of budgeting

1. Requires management to plan ahead

2. Provides definite financial objectives for all levels

of responsibility

3. Creates an early warning system for problems

4. Facilitates coordination of activities

5. Results in greater management awareness ofoperations and external factors

6. Contributes to positive behaviour patterns


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Essentials of effective

budgeting

Clearly defined areas of authority and responsibility

Realistic goals Acceptance by all levels of management

Participation by managers in setting budgets

Review of differences between actual and expected

results


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Length of the budget period

A budget may be prepared for any

period of time Most common budget period is one year

This annual budget is often

supplemented with quarterly andmonthly budgets


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The budgeting process

The development of next years budget begins before end of

current year

The budget starts with a sales forecast which should

consider:

General economic conditions

Industry trends

Market research studies

Anticipated advertising and promotion

Previous market share

Changes in prices

New products

Technological developments


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Budgeting and long-range planning

Long-range planning is a formalised process of

Selecting strategies to achieve long-term goals, and

Developing policies and plans to implement thestrategies

Usually encompasses 35 years

Long-range budgets

Contain less detail than annual budgets

Have a strategic emphasis


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The master budget

The master budget is a set of interrelated budgets

It consists of:

Operating budgets (sales and production) which lead to

the budgeted income statement

Financial budgets (cash budget and budgeted balance

sheet) that are concerned with cash resources forexpected operations and capital expenditure


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Cash budget

This budget shows anticipated cash flows

It combines ending cash balance from previous

period plus details from other budgets

The annual cash budget is often detailed on monthly

basis to reflect anticipated levels of activities

It helps plan for cash excesses and shortfalls


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Cash budget continued

The cash budget has three sections:

Cash receipts: expected cash inflows from customers,

interest, dividends, planned sales of assets and shares

Cash payments: expected cash outflows for direct materials

and labour, overheads, selling & administration costs, taxes,

dividends, assets

Financing: expected cash borrowings and repayments of

borrowings


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Budgeted income statement

The budgeted income statement is the end product

of the operating budgets

It shows expected profitability for budget period

It combines individual operating budgets plus

additional expenses (e.g. interest, taxes)

It forms a basis for performance evaluation


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Merchandising entities

Sales budget is the starting point

Sales budget drives the master budget

Master budget incorporates departmental budgets

Purchases budget used instead of production budget

Purchases budget shows estimated cost of goods

needed to meet sales


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Service entities

Expected output drives master budget

Levels of staff planned to match anticipated levels of

service

Profitability affected by: overstaffing (excessive labour costs) and

understaffing (client dissatisfaction thus low revenue)

Service revenue determined by billing time andservices offered


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BUDGETARY CONTROLCOMPONENTS

cont.


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Management by exception

Budget reports reviewed when actual andbudgeted results differ significantly

Management focus on problem areas

Two guidelines are generally used to identifylevel of significance:

Materiality: variance from budget by more than apredetermined amount

Controllability: ability of manager to influence item


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THE CONCEPT OFRESPONSIBILITY ACCOUNTING

Involves accumulating and reporting costs and

revenues on the basis of the managers with authority

to make decisions concerning the items

Personalises management accounting systems

Performance reports relate only to controllable items

Effectiveness can be measured and reported at all

management levels


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THE CONCEPT OFRESPONSIBILITY ACCOUNTING

continued

Especially valuable in a decentralised entity

Decentralisation means that control has been

delegated to many individual managers throughoutthe organisation

Asegment is an area of responsibility within

decentralised organisation

Each manager prepares regular reports for individualarea of responsibility

THE CONCEPT OF


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THE CONCEPT OFRESPONSIBILITY

ACCOUNTING continued


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TYPES OF RESPONSIBILITY CENTRES

Cost centres

Incur costs but do not directly generate revenues

Managers evaluated on ability to control costs

Examples:

production departments

service centres

Profit centres

Incur costs but also generate revenues Managers evaluated on profitability of their centres

Examples:

Individual departments of a retail store

Branch offices of banks


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TYPES OF RESPONSIBILITYCENTRES continued

Investment centres

Incur costs, generate revenues and

have control over investment fundsavailable for use

Managers evaluated on:

Profitability of the centre Rate of return earned on funds used


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Part 2: INCREMENTAL ANALYSIS

The process of identifying relevant financial data that

changes under alternative courses of action

This may affect costs and/or revenues

It may also affect decisions on future earnings

It involves estimates and uncertainty

Alternatives are evaluated using financial data


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How incremental analysisworks

Important to recognise that:

Variable costs may not differ

Fixed costs may change according toalternatives

Three important concepts:

1. Relevant costs2. Opportunity costs

3. Sunk costs


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How incremental analysisworks continued

Relevant Costs

Focus only on those costs and revenues that differ

across alternatives

Opportunity Costs

Refers to the potential benefit that must be given

up because one course of action is chosen rather

than another

e.g. If a machine is used to make one product, the benefit

of making another product with that machine is lost


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How incremental analysisworks continued

Sunk Costs

Refers to costs that have already been incurred

and will not be changed or avoided by any futuredecision

e.g. If you have already purchased a machine and now a

newer, more efficient machine is available, the

carrying cost of the original machine is a sunk cost andhas no bearing on future decisions

Sunk costs are not relevant costs


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Types of incremental analysis

1. Accept an order at a special price

2. Make or buy component parts orfinished products

3. Sell products or process them further

4.

Retain or replace equipment5. Eliminate an unprofitable business

segment

Examples provided in Chapter 18, pp 1060-1065


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Types of incremental analysiscontinued

Accept an order at a special price

Decision to accept or not depends on: Revenues and costs that would change if

the order was accepted (relevant data)

Effects on other markets and customers

Whether excess production capacity existsor not


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Make or buy

Manufacturing or outsourcing items

depends on: Relevant costs

Productive capacity that cannot be better

used elsewhere (opportunity costs)Analysis of qualitative factors

(e.g. effects on employees, stability ofbusiness environment)


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Sell or process further

Selling item as it is or undertaking

further processing depends on: Incremental revenue exceeding

incremental costs

Consideration of only relevant data Qualitative factors (e.g. reliability of

alternative outsourcing)


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Retain or replace equipment

Decision to replace equipment or continue

using existing assets depends on: Costs that change plus cost of new equipment

Remembering carrying cost of existing asset is

irrelevant (sunk cost) Revenue from sale of existing asset is relevant

(e.g. trade-in or cash value)


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Eliminate an unprofitable segment

Retention or elimination of business segment depends on:

Analysis of relevant data (variable and fixed costs plus

revenues)

Basis of analysis usually instigated from lack of

profitability Consideration of qualitative effects

(e.g. sales of related product lines, employee

conditions)


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Outsourcing

Refers to utilising experts from outside the entity to

perform specific tasks

It enables management to spend less time on areas

where it has limited expertise

Examples

IT is becoming increasingly sourced Fuji Zerox offers services to manage documents, print-room

facilities and office equipment


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Qualitative factors

Quantitative factors refer to those attributes that can

be expressed easily in terms of numbers or dollars

Qualitative factors may also have important potential

effects on decision making, but may be difficult to

measure

Example How will closing an area of operations affect the community

where factory is located?

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