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Activity Based Costing

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Flexible Budgets and Variances

Budgets

• After a strategy has been planned, we use a budget to quantitatively describe financial (the financial statements) and nonfinancial (expansion of new stores, number of employees, ect.) information.
• Budgets are not amazing creations, they are a managerial tool.  The budget should not be the end all.  Many circumstances will require an alteration to the budget.  Management should be flexible and adaptive to the constantly changing environment and utilize budget variances as feedback to review company strategy, planning, and performance.
• These are not mechanical tools.  They are simply putting a plan down into writing so we can take action and know where we are trying to go.  The emphasis should not be on exactly obtaining the budget – it is not an ends in itself.
• Many employees set the bar low, so they can over-deliver.  This is referred to as Budgetary Slack.  However, it has been shown that employees improve performance if budgets are challenging, but attainable.  There are many ways companies refine employee evaluation to help prevent the use of budgetary slack, such as having the employee produce two budgets (expected and aggressive) or evaluate an employee on how accurate they were able to forecast results within their control (rather than if they just beat the earnings or not.
• They also assist in analyzing the effects of changes (whether a change in sales price, volume, increased raw materials cost, ect.) – the analysis of possible scenarios is referred to as Sensitivity Analysis
• The budgeting steps are:
• Coordination between various levels of management to plan the company’s performance
• Based on the plan, set expectations for each manager and the company as a whole, so they have a benchmark to compare actual performance
• When variations occur, management should analyze why the variation occurred
• Based on the additional information, management may refine the budget, adjust the plan, or change the strategy.  Feedback.
• Allows for evaluation of the company’s strategy
• Allows for early warning signs that management’s expectations may not be correct – and they can refine the plan or take advantage of opportunities
• The Reasons for a budget are:
• Planning is a proactive role for management.  It necessitates knowledge of the business environment, understanding of the company’s strategy, and deciding how a company’s limited resources will be utilized.
• A budget will be based on a plan which fulfills a company’s strategy.  However, the feedback from the short or long-term budget will help management analyze the effectiveness/appropriateness of the plan or strategy. (It is one large circle.)
• Quantitatively describes the company’s plan throughout the organization and encourages communication between divisions/departments
• Encouraging communication within an organization is vital to run an efficient company. 
• We want to make sure the company’s interest are the employee’s main focus, not themselves or their own division
• Coordination is the compromising and integration of a company’s divisions, resources, and process to optimally pursue the company’s goals
• Used to motivate employees
• A challenging, yet achievable budget will encourage employees to work harder
• Allows for performance evaluation
• Sometimes we cannot (or may not want to) compare an employee’s performance against prior performance, a budget allows to focus on the future.
• Here is what we expect the employee to accomplish.  How did he/she do?  Why did variances occur?
• Remember variances aren’t a bad thing – they are just different from what is planned.  They highlight where we estimated incorrectly.  Whether good or bad variances, they provide feedback on the employee, the plan, and the strategy
• The budget is set for a specific time frame
• Budgets may focus on the long-term planning or short-term planning of an organization.
• The short-term planning typically has a time frame of a year.
• Budgets may be created at any point in time.  However, instead of being an annual process, some companies keep management constantly involved in the budget by maintaining a rolling budget, so that when one month/quarter passes by, another one month/quarter is added on – therefore the budget constantly has a length of a year (or whatever other given timeframe)
• Kaizen Budgeting involves the continuous search for improvement.  Employees are constantly challenged to become more efficient and reduce costs each month/quart/year.  These expectations are factored into upcoming budgets.
• Since Activity Based Costing has successfully allowed management to track more accurate costs, it makes sense to expand the model into budgeting, thus Activity-Based Budgeting.  Management budgets costs for each activity and can therefore pinpoint variances to a specific area, rather than a generalization that needs to be investigated to find the real problem.

The Master Budget

• The Master Budget details the entire initial plan of the company.  How the company will operate and how it will finance those operations.
• The Master Budget is a set of proforma financial statements (budgeted financial statements)
• Operating Budget refers to the estimated income statement and supporting budgets (revenue, production, marketing, administration, ect.)
• Financial Budget refers to the budgeted balance sheet and statement of cash flows.  These statements describe how the Operating Budget will get the resources needed to operate.  They also describe the longer-term investments necessary to maintain/improve the business.
• Creating a Master Budget involves many steps and estimates.  Communication and coordination is critical.
• First, we must estimate revenues.  The Revenues Budget forecasts sales and, therefore, the quantity of product required for the company to obtain.
• Second, if we are a manufacturing company, we would prepare a Production Budget.  Using the quantity forecasted, we can compute what we need to budget.
• Budgeted Production = Budgeted unit sales + Target Finished Goods – Beginning Inventory
• Third, since we know how much we are going to produce, we can then budget the quantities of materials we need for production.  Material Purchase Budget describes the resources we need to acquire.
• Budgeted Purchases of Direct Materials = Budgeted Production Use + Target Ending Direct Materials – Beginning Direct Materials
• Fourth, we can anticipate the amount of labor necessary to convert the direct materials - the Direct Manufacturing Labor Budget
• Fifth, we prepare the Overhead Budget based on the information we have acquired from the previous production budgets and knowledge of Cost Allocation Bases
• Sixth, we can prepare Ending Inventory Budgets.  Dealing with finished goods, the company’s inventory flow method (FIFO, LIFO, weighted average) is employed.
• Seventh, the Ending Inventory Budget contains the information for creating the Cost of Goods Sold Budget.
• Eighth, the Operating Expense Budget (Nonmanufacturing Costs Budget) is created to anticipate other expenses the company will incur.
• Finally the Budgeted Income Statement may be prepared.

Activity Based Costing

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Flexible Budgets and Variances