6.1 The planning process
6.1.1 Basic definitions
•budget: a budget is a monetary statement of what it is reasonable to believe can be made to happen, and it is prepared and approved in precedence to the budget period.
•budget committee: the membership of the budget committee varies according to the size and nature of the organization, a typical one comprises at least the chief executive, the management accountant(acting as budget officers) and functional heads.
•budget manual: a formal statement of budgeting procedures, including the objectives and description of the system, procedures to be followed together with the specimen forms and statements to be completed.
•the principal budget factor: a factor which will limit the activities of an organization and which is often the starting point in budget preparation. In general, it is the volume of the demand for the product (sales) which limits the scale of operation.
•the master budget: a budget integrates all subsidiary budget, which normally includes budgeted profit and loss account,

budgeted balance sheet as well as budgeted cash flow statement( cash budget).
6.1.1 Overview of the planning process
(1) identify objectives. A company specifies objectives towards which it is working.
(2) search for alternative sources of action. A Serials of specific strategies including exploring new markets for existing products, developing new products for existing markets or new products for new markets should be developed.
(3) gather data about alternatives and measure pay-offs.
(4) select course of action. Long-term based on above are created.
(5) implement long-term plan, which signals the move from long-term planning to annual budgeting which is an integral part of the long-term planning process.
(6) monitor actual outcomes, keeping detailed financial and other records of actual performance compared with budget targets

(variance analysis).
(7) respond to divergences from plan. This is the control process in budgeting, responding to divergences from plan either through budget modification or though identifying new courses of action.
6.1.2 Pros and cons of budgetary control system.
Argument for:
planning and co-ordination
Success in business is closely related to success in planning for the future. In this
context the budget serves three functions:
•it provides a forma1planning framework that ensues planning does take place
•it co-ordinates the various separate aspects of the business by providing a master
plan (the master budget)for the business as a whole (this is particularly important
in a large organisation engaged in making several different products, where
otherwise it is too easy for individual managers to concentrate on their own aspects
of the business)
-though not all decisions can be anticipated, the budget provides a framework of
reference within which later operating decisions can be taken.
Authorizing and delegating
Adoption of a budget by management explicitly authorizes the decisions made within it. This serves two functions:
•the need continuous1y to ask for top management decisions is reduced;
•the responsibility for carrying out the decisions is delegated to individual managers.
Evaluating performance
One of the functions of accounting information is that it provides a basis for the
measurement of managerial performance. By setting targets for each manager to
achieve, the budget provides a bench-mark against which his actual performance can be assessed objectively.
Note, however, that before a budget can be used successfully for this purpose,1t must be accepted as reasonable by the individual manager whose area of responsibility it
covers and whose performance is to be evaluated.
Discerning trends
It is important that management should be made aware as soon as possible of my new
trends, whether in relation to production or marketing. The budget by providing
specific expectations with which actual performance is continuously compared, supp1ies a mechanism for the early detection of any unexpected trend.
Communicating and motivating
The application of budgeting within an organisation should lead to a good
communications structure. Managers involved in the setting of budgets for their own
responsibility need to have agreed strategies and policies communicated down to them.
A good system of downwards communication should itself encourage good upwards
and sideways communication in the organisation. Budgets that have been agreed by
managers should provide some motivation towards their achievement.
Control
Once the budgets have been set and agreed for the future period under review, the
forma1 control element of budgetary control is ready to start. This control involves the comparison of the plan in the form of the budget with the actual results achieved for the appropriate period. Any significant divergences between the budgeted

and the actual results should be reported to the appropriate management so that the necessary action can be taken.
Argument against:
•There may be a general fear and misunderstanding about the purpose of
budgetary control. It is often regarded as a penny-pinching exercise rather than
recognized as a tool of management at a11 levels in an organisation structure.
If this tends to be the attitude, a carefully planned campaign of education and
understanding should be under taken. Managers should be encouraged to discover
what is in the budgetary control system for them.
•Employees may become united against management and devote their energies to
finding excuses for not meeting targets.
Targets that are realistic, and are seen by the employees as being realistic, are what
is required. Good communications involving consultation and participation should
help to minimize this problem.
•One of the key roles in my organisation is at the supervisor/foreman level where
the continual interface between management and employees exists. The leadership
and motivational function of a supervisor or foreman is very important if the work
is to be done and targets are to be achieved.
•The breaking down of an organisation into many sub-areas of managerial
responsibility can lead to sub-optimisation problems as far as the whole company
is concerned, i.e. the optimisation of an individual manager’s department or section
at the expense of the organisation overall.
Such dysfunctional behavior should be minimized. It reflects a lack of goal congruence.
If budgets are built up from the base of the organisation, with individual departmental budgets providing the input to the overall master budget, the tendency to incorporate slack into budgets needs to be carefully monitored.
Some desirable projects could be lost because they were not foreseen and therefore not budgeted for. The system needs to be flexible enough to avoid this problem.
6.1.3 Preparation of the master budget.
Case
6.2 using budgets to control and motivate
6.2.1 fixed budget
a fixed budget is a budget which shows income/costs for a single level of activity and makes no attempt to separate costs into those which are fixed and those which are variable.
6.2.2 flexible and flexed budget
•flexible budget is a serials of budgets for various levels of activity, or ranges of activity levels.
•flexed budget is a budget prepared for the actual level of activity.
6.2.3 participation in budget setting
•imposed budgets-theory x: the theory x style of management is authoritarian, based on direction and control down through the organization and typified by a host of rules and regulations.
Theory x is based on the assumption that people in working environment are basically lazy and dislike work as well as any responsibility associated with it. They are motivated by money to meet their basic needs.
•participative budgets-theory y: this is a theory based on the assumption that people seek more responsibility and do not have to be so tightly controlled.
6.3 Alternative budgetary systems
6.3.1 rolling budgets
•definition: rolling budgets is a budget continuously updated by adding a further period, say a month or quarter, and deducting the earliest period. Beneficial where future costs or activities can not be forecast reliably.
•pros and cons of rolling budgets
(1) advantages of rolling budgets
•Budgets are more realistic and achievable since they are continuously revised to
reflect changing circumstances.
•The annual disruption associated with the preparation of an annual budget is removed.
•The pressures (and stress)placed on managers to achieve unrealistic budget targets
are eased.
•Variance feedback is more meaningful
•It tends to reduce budgetary bias.
•It reduces the rigidity of the budget system and builds contingency and innovation
into the preparation/feedback stages of the control system.
•The assessment of objectives and plans is continuous rather than being a one-OE
exercise.
•Without some form of budget revision, operational management may continue to
invest and recruit, etc with the belief that management strategy holds firm.
•It might help to increase management commitment to the budget.
•The arbitrary and artificial distinction drawn between one financial year and the
next is removed, since budgets always extend for a year ahead.
(2)disadvantages of rolling budgets:
•If it is difficult to plan ahead accurately (and it always is!)when once a year
managers spend a lot of time and effort on the task, how likely is it that managers
can do the same forecasts more accurately every month or quarter when they are
involved in other responsibilities?
•There is a danger that the rolling budget will become the last budget ‘plus or minus
a bit’and will be representative of absolutely nothing in terms of corporate
objectives and meaningless for performance control purposes.
•Managers will be faced with a greater work load and additional staff may be
required.
•Managers may devote insufficient attention to preparing budgets which they how
will shortly be revised.
•The organisation might be required to operate annual budgets (such as enterprises
operating in the public sector).
6.3.2 zero based budgeting (ZBB)
(1) definition: ZBB is a method of budgeting whereby all activities are reevaluated each time a budget is prepared. Discrete levels of each activity are valued and a combination chosen to match funds available.
(2) ZBB technique:
•first step: development of decision package, which is a document that identifies a specific activity in such a manner that management can evaluate it and rank it in order to decide whether to approve or disapprove it.
•second step: using cost/benefit analysis, the decision package is evaluated and ranked.
• third step: the result is a list of ranked activities which senior management can use to evaluate needs and priorities in allocating resource for the forthcoming budget period.
(3) pros and cons of ZBB
benefits of ZBB
•It helps to create an organizational environment where change is accepted.
•It helps management to focus on company objectives and goals.
•It concentrate the attention of management on the future rather than on the past.
•It helps to identify inefficient and obsolete operations within the organisation.
•It provides a framework to ensure the optimum utilisation of resources by
estab1ishing priorities m relation to operational activity.
•It can assist motivation of management at all levels.
•It provides a plan to follow when more financial resources become available.
•It establishes minimum requirement.
weakness of ZBB
•It takes more management time than conventional systems, in part because
managers need to learn what is required of them.
•There is a temptation to concentrate on short-term cost savings at the expense of
longer-term benefits.
•It takes time to show the real benefits of implementing such a system.
6.3.3 Activity based budgeting (ABB)
(1) definition: ABB is a method of budgeting based on an activity framework and utilizing cost driver data in the budget-setting and variance feedback processes.
(2) procedure of ABB
•step one: the work of each department where a budget is to be prepared is analyzed by its major activities, for which cost drivers may be identified.
•step two: the budgeted cost of resources used by each activity is determined and, where appropriate, cost per unit of activity is calculated.
•step three: future cost can then be budgeted by deciding on future activity levels and working back to the required resource input.
(3) pros and cons of ABB
•the cost of activities are identified.
•It takes into account the impact of activity levels on resource costs, of assistance in cost reduction programmes and in setting realistic cost targets.
•Activity unit costs allow easier analysis of cost trends over time and intra-departmental comparisons.
•Resource allocation decisions are assisted by the activity related cost information arising from an ABB system.
•ABB links directly to a total quality management(TQM) programme by relating activity costs to the service level achieved and enabling internal users of the service to ask whether they are getting value for money.
• It should encourage managers to ask how the activity can be carried out more effectively and thereby assist in process improvement exercise.
6.4 Quantitative aids to budgeting
6.4.1 cost prediction
(1)the engineering approach
•definition: this approach is based on building up a complete specification of all inputs required to produce given levels of output; these are then costed out at expected input prices.
•this approach works reasonably well in a single product or start-up situation.
but it does not fit in a multi-product situation or the exact output mix is unknown.
(2) the account analysis approach
•definition: this approach uses information contained in the historical ledger accounts, which are analyzed and categorized as either fixed or variable.
•this approach does not always indicate the true nature of costs.
accounts are by their nature summaries and often contain transaction of different categories.
it rests on historical data.
(3) scatter diagrams (also called scatter charts)
•definition: Scatter diagrams gives a vivid display of past relationship, with x-axis on behalf of the cause, the independent variable, and y-axis on behalf of the effect, the dependent variable.
•correlation: one advantage of a scatter diagrams is that it is possible to see quite easily if the points indicate that a relationship exists between the variables, i.e. to see if any correlation exists between them.
* perfect linear correlation: if the points lie in a straight, this is perfect linear correlation.
* positive correlation: when the values of variables increase together, this is positive correlation.
* negative correlation: when the values of variables increase in opposite way, this is negative correlation.
Note: it is always the dependent variable that is shown on the y axis of a scatter diagram, and the independent variable on the x axis. For example, the size of inspection costs depends on the number of units output, so inspection costs are shown on the y axis and output on the x axis.
•line of best fit
the equation for any straight line is of the form: y =a +bx. If we try to predict total cost from past data of costs and activity levels then :
y is total cost;
a is fixed cost;
b is variable cost per unit;
x is the activity level.
(4) high-low method
•definition: the high-low method finds the equation of the straight line joining the two points corresponding to the highest and lowest activity levels.
•case:
monthly sales(units) distribution cost($)
high 1,000 480
low 400 330
dif 600 150
Solution:
Variable cost: 150/600=$0.25 per unit
Fixed cost=330-400Ｘ$0.25=$230
Total csot=$230+$0.25Ｘunits, i.e. y= 230+0.25x
•limitation:
*it is relied on historical data, assuming that not only activity is the only factor affecting costs but historical costs can reliably predict future costs.
*it is only based on two values, the highest and the lowest, which means that the results may be distorted because of random variations in these values.
(5) regression analysis
•definition: least squares regression is a mathematically derived line of best fit that uses all the data.
•formula: provided in examination.
•case: the total power costs and corresponding production volumes over the last 6 months were recorded and analysed as follows:
Month volume(,000) cost($,000)
x y xy x2
1 3.2 24.2 77.44 10.24
2 1.8 20.6 37.08 3.24
3 2.4 25.8 61.92 5.76
4 2.5 25.2 63.00 6.25
5 1.6 21.4 34.24 2.56
6 3.0 28.2 84.60 9.00
∑x=14.5 ∑y=145.4 ∑xy=358.28 ∑x2 =37.05
b= variable cost per unit=6ｘ358.28-14.5ｘ145.4
6ｘ37.05-14.52
=$3.43
a=fixed cost=145.4/6-(3.43ｘ14.5)/6=15.94 i.e. $15940
y= 15.94+3.43x ( x in hundreds of units produced, y in$1,000s).
•correlation coefficient: a mathematical measure of strength in correlation between two variables. Formula is given in exam.
R=+1, where perfect positive correlation exists;
R=-1, where perfect negative correlation exists;
R=0, where no correlation exists.
R is the closer to +1(-1), the higher the degree of correlation.
•interpolation is when regression lines are used to estimate values of variables within the known range.
•extrapolation is where the line is extended outside the known range, i.e., outside the limits of the original data, which should be treated cautiously as it assumes the same relationship is continuous.
6.4.2 Time series analysis
(1) definition: a time series is a set of observation taken at equal intervals of time, components are following:
•long-term trend(T): the long-term effect when fluctuations have been smoothed out;
•cyclical variation(C): a cyclical fluctuation over a number of years, which is due to the influence of booms and slumps in economy.
•seasonal variation(S): an annual cycle of variation due to seasonal influences;
•residual or random variation(R): randomly occurring variations due to non-recurring influences.
(2) additive and multiplicative models
•additive model: A=T+C+S+R, where A is the actual value. Suitable when the fluctuations about the trend are within a constant

band width.
•multiplicative model: A= TｘCｘSｘR. suitable when the fluctuations about the trend increase as the trend increases.