DECISION MAKING IN RESPONSIBILITY

CENTRES

This chapter follows on from your CIMA P1 are vital for both planning and control. Section 2 shows
studies of budgeting and focuses on how how they are constructed and Section 4 looks at their use
budgets can be used for control purposes. in the overall budgetary control process.

Budgetary control is the comparison of actual results The chapter then considers the behavioural implications
with budgeted results. Variances are calculated to of operating a budgetary control system. As in all studies
identify the differences between actual and budgeted of human behaviour, it is difficult to draw concrete
results and these differences are reported to conclusions. There is, however, one point which is agreed:
management so that appropriate action can be taken. budgeting is more than a mathematical technique.

Such an approach relies on a system of flexible (as The chapter concludes with a review of the criticisms of
opposed to fixed) budgets. We look at the difference budgeting and the recommendations of the advocates of
between the two types in Section 2. Flexible budgets 'Beyond Budgeting'.

topic list learning outcomes syllabus references ability required

1 Responsibility centres B1(b), B3(a) B1(b)(i), B3(a)(i), (ii) application
2 Fixed and flexible budgets B1(a) B1(a)(i) analysis

3 Preparing flexible budgets B1(a) B1(a)(i) analysis

4 Flexible budgets and budgetary control B1(a), (b) B1(a)(i), (b)(i) application
5 Behavioural implications of budgeting B2(c) B2(c)(i) analysis

6 Budget participation B2(c) B2(c)(i) analysis

7 The use of budgets as targets B2(c) B2(c)(i) analysis

8 Budgets and motivation B2(c) B2(c)(i) analysis

9 Beyond Budgeting B2(c) B2(c)(ii) analysis

193
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Chapter Overview

Decision making in
responsibility centres

Cost, profit and investment Performance reports Budgeting

centres

Cost Behavioural aspects of

centre budgeting

Profit
centre
Beyond budgeting
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1 Responsibility centres

Introduction
This section focuses on the responsibility centre business model. Make sure you familiarise yourself with
the different categories of responsibility centre and what they can control (costs, profit, investment).

1.1 Divisionalisation
In general, a large organisation can be structured in one of two ways: functionally (all activities of a
similar type within a company, such as production, sales, research, are under the control of the
appropriate departmental head) or divisionally (split into divisions in accordance with the products or
services made or provided).

Divisional managers are therefore responsible for all operations (production, sales and so on) relating to
their product, the functional structure being applied to each division. It is possible, of course, that only
part of a company is divisionalised and activities such as administration are structured centrally on a
functional basis with the responsibility of providing services to all divisions.

1.2 Decentralisation
In general, a divisional structure will lead to decentralisation of the decision-making process and
divisional managers may have the freedom to set selling prices, choose suppliers, make product mix and
output decisions and so on. Decentralisation is, however, a matter of degree, depending on how much
freedom divisional managers are given.

1.3 Advantages of divisionalisation

(a) Divisionalisation can improve the quality of decisions made because divisional managers (those
taking the decisions) know local conditions and are able to make more informed judgements.
Moreover, with the personal incentive to improve the division's performance, they ought to take
decisions in the division's best interests.

(b) Decisions should be taken more quickly because information does not have to pass along the
chain of command to and from top management. Decisions can be made on the spot by those who
are familiar with the product lines and production processes and who are able to react to changes
in local conditions quickly and efficiently.

(c) The authority to act to improve performance should motivate divisional managers.

(d) Divisional organisation frees top management from detailed involvement in day-to-day operations
and allows them to devote more time to strategic planning.

(e) Divisions provide valuable training grounds for future members of top management by giving
them experience of managerial skills in a less complex environment than that faced by top
management.

(f) In a large business organisation, the central head office will not have the management resources or
skills to direct operations closely enough itself. Some authority must be delegated to local
operational managers.
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1.4 Disadvantages of divisionalisation

(a) A danger with divisional accounting is that the business organisation will divide into a number of
self-interested segments, each acting at times against the wishes and interests of other segments.
Decisions might be taken by a divisional manager in the best interests of his own part of the
business, but against the best interest of other divisions and possibly against the interests of the
organisation as a whole.

A task of head office is therefore to try to prevent dysfunctional decision making by individual
divisional managers. To do this, head office must reserve some power and authority for itself so
that divisional managers cannot be allowed to make entirely independent decisions. A balance
ought to be kept between decentralisation of authority, to provide incentives and motivation, and
retaining centralised authority, to ensure that the organisation's divisions are all working towards
the same target, to the benefit of the organisation as a whole (in other words, retaining goal
congruence among the organisation's separate divisions).

GOAL CONGRUENCE 'In a control system is the state which leads individuals or groups to take actions
which are in their self-interest and also in the best interest of the entity.'
KEY TERM
(CIMA Official Terminology)

(b) It is claimed that the costs of activities that are common to all divisions, such as running the
accounting department, may be greater for a divisionalised structure than for a centralised
structure.

(c) Top management, by delegating decision making to divisional managers, may lose control, since
they are not aware of what is going on in the organisation as a whole. (With a good system of
performance evaluation and appropriate control information, however, top management should be
able to control operations just as effectively.)

1.5 Responsibility accounting

RESPONSIBILITY ACCOUNTING is a system of accounting that segregates revenue and costs into areas of
personal responsibility in order to monitor and assess the performance of each part of an organisation.
KEY TERM
The creation of divisions allows for the operation of a system of responsibility accounting. There are a
number of types of responsibility accounting unit or responsibility centre that can be used within a system
of responsibility accounting.

In the weakest form of decentralisation a system of cost centres might be used. As decentralisation
becomes stronger, the responsibility accounting framework will be based around profit centres. In its
strongest form investment centres are used.

Type of responsibility centre Manager has control over … Principal performance

measures
Cost centre Controllable costs Variance analysis
Efficiency measures
Revenue centre Revenues only Revenues
Profit centre Controllable costs Profit
Sales prices (including transfer prices)
Investment centre Controllable costs Return on investment
Sales prices (including transfer prices) Residual income
Output volumes Other financial ratios
Investment in non-current assets and
working capital
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1.6 Cost centres

A cost centre manager is responsible for, and has control over, the costs incurred in the cost centre. The
manager has no responsibility for earning revenues or for controlling the assets and liabilities of the
centre.

Cost centre organisations can be relatively easy to establish because, as you will recall from your earlier
studies, a cost centre is any part of the organisation to which costs can be separately attributed. A cost
centre forms the basis for building up cost records for cost measurement, budgeting and control.

Functional departments such as production, personnel and marketing might be treated as cost centres
and made responsible for their costs.

A performance report for a cost centre might look like this.

COST CENTRE X
PERFORMANCE REPORT FOR THE PERIOD
Budgeted activity: (units)
Actual activity: (units)
Budgeted Budgeted Actual
costs costs costs Variance
(original) (flexed)
$ $ $ $
Material costs
Labour costs
Variable overhead costs
Depreciation costs
etc

Two important points to note about this report are as follows.

(a) The report should include only controllable costs, although, as we have seen, there is a case for
also providing information on certain uncontrollable costs. However, there should be a clear
distinction in the report between controllable costs and uncontrollable costs.

(b) The actual costs are compared with a budget that has been flexed to the actual activity level
achieved. This approach provides better information, for the purposes of both control and
motivation as we will see later in this chapter.

The use of flexible budget information is appropriate for control comparisons in production cost centres,
but the costs attributed to discretionary cost centres are more difficult to control. Examples of
discretionary cost centres include advertising, research and development and training cost centres.
Management has a significant amount of discretion as to the amount to be budgeted for the particular
activity in question.

Moreover, there is no optimum relationship between the inputs (as measured by the costs incurred) and
the outputs achieved. Fixed budgets must be used for the control of discretionary costs.
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Question 5.1 Responsibility accounting

Learning outcome B2(c)

Explain the meaning and importance of controllable costs, uncontrollable costs and budget cost allowance
in the context of a system of responsibility accounting.

1.7 Revenue centres

The manager of a revenue centre is responsible only for raising revenue but has no responsibility for
forecasting or controlling costs. An example of a revenue centre might be a sales centre.

Revenue centres are often used for control purposes in not-for-profit organisations such as charities. For
example, a revenue centre manager may have responsibility for revenue targets within an overall
fundraising exercise, but that manager does not control the costs incurred. Such responsibility would
pass to a more senior manager to whom the revenue centre manager reports.

1.8 Profit centres

A PROFIT CENTRE is a part of a business accountable for both costs and revenues.

KEY TERM
For a profit centre organisation structure to be established, it is necessary to identify units of the
organisation to which both revenues and costs can be separately attributed. Revenues might come from
sales of goods and services to external customers, or from goods and services provided to other
responsibility centres within the organisation. These internal 'sales' are charged at a notional selling price
or transfer price. We will return to look at transfer prices in detail in Chapter 7.

A profit centre's performance report, in the same way as that for a cost centre, would identify separately
the controllable and non-controllable costs. A profit centre performance report might look like this.

PROFIT CENTRE Y
STATEMENT OF PROFIT OR LOSS FOR THE PERIOD
Budget Actual Variance
$'000 $'000 $'000
Sales revenue X X
Variable cost of sales (X) (X)
Contribution X X
Directly attributable/controllable fixed costs
Salaries X X
Stationery costs X X
etc etc

(X) (X)
Gross profit (directly attributable/controllable) X X
Share of uncontrollable costs (eg head office costs) (X) (X)
Net profit X X
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Again, the budget for the sales revenue and variable cost of sales will be flexed according to the activity
level achieved.

The variances could be analysed in further detail for the profit centre manager.

Notice that three different 'profit levels' are highlighted in the report.

(a) Contribution, which is within the control of the profit centre manager

(b) Directly attributable gross profit, which is also within the manager's control

(c) Net profit, which is after charging certain uncontrollable costs and which is therefore not
controllable by the profit centre manager.

1.9 Attributable costs and controllable costs

In the example of profit centre Y we have assumed that all attributable costs are controllable costs.
Although this is usually the case, some care is needed before this assumption is made.

In responsibility accounting, an attributable cost is a cost that can be specifically identified with a
particular responsibility centre. No arbitrary apportionment is necessary to share the cost over a number
of different responsibility centres.

You can see, therefore, that most attributable costs will be controllable costs. An example of an
attributable fixed cost is the salary of the supervisor working in a particular responsibility centre.

However, think about the depreciation of the equipment in profit centre Y. This is certainly attributable to
the profit centre, but is it a controllable cost? The answer is probably 'no'. It is unlikely that the manager
has control over the level of investment in equipment in profit centre Y, otherwise the centre would be
classified as an investment centre.

Therefore it might be necessary to include a third measure of 'profit' in our performance report, which
would be the controllable profit before the deduction of those costs which are attributable to the profit
centre, but which are not controllable by the profit centre manager.

Exam alert
If an assessment question requires you to prepare a performance report for a responsibility centre, read
the information carefully to distinguish controllable attributable and non-controllable costs, and then state
clearly any assumptions you need to make in order to distinguish between them.

1.10 Investment centres

An INVESTMENT CENTRE is a 'Profit centre with additional responsibilities for capital investment and
possibly for financing, and whose performance is measured by its return on investment'.
KEY TERM (CIMA Official Terminology)

Where a manager of a division or strategic business unit is allowed some discretion about the amount of
investment undertaken by the division, assessment of results by profit alone (as for a profit centre) is
clearly inadequate. The profit earned must be related to the amount of capital invested. Such divisions are
sometimes called investment centres for this reason. Performance is measured by return on capital
employed (ROCE), often referred to as return on investment (ROI) and other subsidiary ratios, or by
residual income (RI).

Managers of subsidiary companies will often be treated as investment centre managers, accountable for
profits and capital employed. Within each subsidiary, the major divisions might be treated as profit
centres, with each divisional manager having the authority to decide the prices and output volumes for
the products or services of the division. Within each division, there will be departmental managers,
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section managers and so on, who can all be treated as cost centre managers. All managers should receive
regular, periodic performance reports for their own areas of responsibility.

The amount of capital employed in an investment centre should consist only of directly attributable non-
current assets and working capital (net current assets).

(a) Subsidiary companies are often required to remit spare cash to the central treasury department at
group head office, and so directly attributable working capital would normally consist of inventories
and receivables less payables, but minimal amounts of cash.

(b) If an investment centre is apportioned a share of head office non-current assets, the amount of
capital employed in these assets should be recorded separately because it is not directly
attributable to the investment centre or controllable by the manager of the investment centre.

Section summary
There are a number of advantages and disadvantages to divisionalisation. The principal disadvantage is
that it can lead to dysfunctional decision making and a lack of goal congruence.

Responsibility accounting is the term used to describe decentralisation of authority, with the performance
of the decentralised units measured in terms of accounting results.

With a system of responsibility accounting there are three types of responsibility centre: cost centre,
profit centre and investment centre.

2 Fixed and flexible budgets

Introduction
This section is a reminder of the differences between fixed and flexible budgets. You should know about
fixed and flexible budgets from your earlier studies.

2.1 Fixed budgets

The master budget prepared before the beginning of the budget period is known as the fixed budget. By
the term 'fixed', we do not mean that the budget is kept unchanged. Revisions to a fixed master budget
will be made if the situation so demands. The term 'fixed' means the following.

(a) The budget is prepared on the basis of an estimated volume of production and an estimated
volume of sales, but no plans are made for the event that actual volumes of production and sales
may differ from budgeted volumes.

(b) When actual volumes of production and sales during a control period (month or four weeks or
quarter) are achieved, a fixed budget is not adjusted (in retrospect) to represent a new target for
the new levels of activity.

The major purpose of a fixed budget lies in its use at the planning stage, when it seeks to define the
broad objectives of the organisation.

A FIXED BUDGET is 'A budget set prior to the control period, and not subsequently changed in response to
changes in activity or costs or revenues. It may serve as a benchmark in performance evaluation.'
KEY TERM (CIMA Official Terminology)

Fixed budgets (in terms of a pre-set expenditure limit) are also useful for controlling any fixed cost, and
particularly non-production fixed costs such as advertising, because such costs should be unaffected by
changes in activity level (within a certain range).
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2.2 Flexible budgets

A FLEXIBLE BUDGET is a budget which, by recognising different cost behaviour patterns, is designed to
change as volume of activity changes.
KEY TERM
Two uses of flexible budgets

(a) At the planning stage. For example, suppose that a company expects to sell 10,000 units of
output during the next year. A master budget (the fixed budget) would be prepared on the basis of
these expected volumes. However, if the company thinks that output and sales might be as low as
8,000 units or as high as 12,000 units, it may prepare contingency flexible budgets, at volumes
of, say 8,000, 9,000, 11,000 and 12,000 units, and then assess the possible outcomes.

(b) Retrospectively. At the end of each control period, flexible budgets can be used to compare actual
results achieved with what results should have been under the circumstances. Flexible budgets are
an essential factor in budgetary control.

(i) Management needs to know about how good or bad actual performance has been. To
provide a measure of performance, there must be a yardstick (budget/ standard) against
which actual performance can be measured.

(ii) Every business is dynamic, and actual volumes of output cannot be expected to conform
exactly to the fixed budget. Comparing actual costs directly with the fixed budget costs is
meaningless.

(iii) For useful control information, it is necessary to compare actual results at the actual level of
activity achieved against the results that should have been expected at this level of activity,
which are shown by the flexible budget.

Section summary
Fixed budgets remain unchanged regardless of the level of activity; flexible budgets are designed to flex
with the level of activity.

Flexible budgets are prepared using marginal costing and so mixed costs must be split into their fixed and
variable components (possibly using the high/low method).

Flexible budgets should be used to show what cost and revenues should have been for the actual level of
activity. Differences between the flexible budget figures and actual results are variances.

3 Preparing flexible budgets

Introduction
This section focuses on how to prepare flexible budgets. Again, this is something that should be familiar
from your previous studies, but make sure you work through the example to reacquaint yourself with the
process.

Knowledge brought forward from earlier studies

The preparation of flexible budgets:

 The first step in the preparation of a flexible budget is the determination of cost behaviour
patterns, which means deciding whether costs are fixed, variable or semi-variable.

 Fixed costs will remain constant as activity levels change.

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 For non-fixed costs, divide each cost figure by the related activity level. If the cost is a linear
variable cost, the cost per unit will remain constant. If the cost is a semi-variable cost, the unit
rate will reduce as activity levels increase.

 Split semi-variable costs into their fixed and variable components using the high/low method or the
scattergraph method.

 Calculate the budget cost allowance for each cost item as budget cost allowance = budgeted fixed
cost* + (number of units produced/sold × variable cost per unit)**.

* nil for totally variable cost ** nil for fixed cost

The BUDGET COST ALLOWANCE/FLEXIBLE BUDGET is the budgeted cost ascribed to the level of activity
achieved in a budget centre in a control period. It comprises variable costs in direct proportion to volume
KEY TERM achieved and fixed costs as a proportion of the annual budget.

Example: Fixed and flexible budgets

Suppose that Gemma expects production and sales during the next year to be 90% of the company's
output capacity, that is, 9,000 units of a single product. Cost estimates will be made using the high-low
method and the following historical records of cost.

Units of output/sales Cost of sales

Yen
9,800 44,400
7,700 38,100

The company's management is not certain that the estimate of sales is correct, and has asked for flexible
budgets to be prepared at output and sales levels of 8,000 and 10,000 units. The sales price per unit
has been fixed at Y5 .

Required

Prepare appropriate budgets.

Solution
If we assume that within the range 8,000 to 10,000 units of sales, all costs are fixed, variable or mixed
(in other words there are no stepped costs, material discounts, overtime premiums, bonus payments and
so on), the fixed and flexible budgets would be based on the estimate of fixed and variable cost.

Yen
Total cost of 9,800 units = 44,400
Total cost of 7,700 units = 38,100
Variable cost of 2,100 units = 6,300

The variable cost per unit is Yen 3.

Yen
Total cost of 9,800 units = 44,400
Variable cost of 9,800 units (9,800  Yen 3) = 29,400
Fixed costs (all levels of output and sales) = 15,000
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The fixed budgets and flexible budgets can now be prepared as follows.

Flexible budget Fixed budget Flexible budget

8,000 units 9,000 units 10,000 units
Yen Yen Yen
Sales ( Yen 5) 40,000 45,000 50,000
Variable costs ( Yen 3) 24,000 27,000 30,000
Contribution 16,000 18,000 20,000
Fixed costs 15,000 15,000 15,000
Profit 1,000 3,000 5,000

3.1 The need for flexible budgets

We have seen that flexible budgets may be prepared in order to plan for variations in the level of activity
above or below the level set in the fixed budget. It has been suggested, however, that since many cost
items in modern industry are fixed costs, the value of flexible budgets in planning is dwindling.

(a) In many manufacturing industries, plant costs (depreciation, rent and so on) are a very large
proportion of total costs, and these tend to be fixed costs.

(b) Wage costs also tend to be fixed, because employees are generally guaranteed a basic wage for a
working week of an agreed number of hours.

(c) With the growth of service industries, labour (wages or fixed salaries) and overheads will account
for most of the costs of a business, and direct materials will be a relatively small proportion of total
costs.

Flexible budgets are nevertheless necessary, and even if they are not used at the planning stage, they
must be used for variance analysis.

Section summary
The budget cost allowance/flexible budget is the budgeted cost ascribed to the level of activity achieved
in a budget centre in a control period. It comprises variable costs in direct proportion to volume achieved
and fixed costs as a proportion of the annual budget.

4 Flexible budgets and budgetary control

Introduction
Flexible budgets are essential for control purposes. They represent the expected revenues, costs and
profits for the actual units produced and sold and are then compared to actual results to determine any
differences (or variances). Variances should already be familiar to you from your P1 studies – in this
section we show how flexible budgets can be used to identify potential control issues.

Budgetary control is carried out via a MASTER BUDGET devolved to responsibility centres, allowing
continuous monitoring of actual results versus budget, either to secure by individual action the budget
KEY TERM objectives or to provide a basis for budget revision'. (CIMA Official Terminology)

In other words, individual managers are held responsible for investigating differences between budgeted and
actual results, and are then expected to take corrective action or amend the plan in the light of actual events.

It is therefore vital to ensure that valid comparisons are being made. Consider the following example.
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Example: Flexible budgets and budgetary control

Penny manufactures a single product, the Darcy. Budgeted results and actual results for May are as
follows.

Budget Actual Variance

Production and sales of the 7,500 8,200
Darcy (units)
$ $ $
Sales revenue 75,000 81,000 6,000 (F)
Direct materials 22,500 23,500 1,000 (A)
Direct labour 15,000 15,500 500 (A)
Production overhead 22,500 22,800 300 (A)
Administration overhead 10,000 11,000 1,000 (A)
70,000 72,800 2,800 (A)
Profit 5,000 8,200 3,200 (F)

Note. (F) denotes a favourable variance and (A) an unfavourable or adverse variance.

In this example, the variances are meaningless for the purposes of control. All costs were higher than
budgeted but the volume of output was also higher; it is to be expected that actual variable costs would
be greater those included in the fixed budget. However, it is not possible to tell how much of the increase
is due to poor cost control and how much is due to the increase in activity.

Similarly, it is not possible to tell how much of the increase in sales revenue is due to the increase in
activity. Some of the difference may be due to a difference between budgeted and actual selling price, but
we are unable to tell from the analysis above.

For control purposes we need to know the answers to questions such as the following.

 Were actual costs higher than they should have been to produce and sell 8,200 Darcys?
 Was actual revenue satisfactory from the sale of 8,200 Darcys?

Instead of comparing actual results with a fixed budget which is based on a different level of activity to
that actually achieved, the correct approach to budgetary control is to compare actual results with a
budget which has been flexed to the actual activity level achieved.

Suppose that we have the following estimates of the behaviour of Penny's costs:

(a) Direct materials and direct labour are variable costs

(b) Production overhead is a semi-variable cost, the budgeted cost for an activity level of 10,000 units
being $25,000
(c) Administration overhead is a fixed cost
(d) Selling prices are constant at all levels of sales

Solution
The budgetary control analysis should therefore be as follows.

Fixed budget Flexible budget Actual results Variance

Production and sales (units) 7,500 8,200 8,200
$ $ $ $
Sales revenue 75,000 82,000 (W1) 81,000 1,000 (A)
Direct materials 22,500 24,600 (W2) 23,500 1,100 (F)
Direct labour 15,000 16,400 (W3) 15,500 900 (F)
Production overhead 22,500 23,200 (W4) 22,800 400 (F)
Administration overhead 10,000 10,000 (W5) 11,000 1,000 (A)
70,000 74,200 72,800 1,400 (F)
Profit 5,000 7,800 8,200 400 (F)
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Workings

1 Selling price per unit = $75,000 ÷ 7,500 = $10 per unit

Flexible budget sales revenue = $10 x 8,200 = 482,000

2 Direct materials cost per unit = $22,500 ÷ 7,500 = $3

Budget cost allowance = $3 x 8,200 = $24,600

3 Direct labour cost per unit = $15,000 ÷ 7,500 = $2

Budget cost allowance = $2 x 8,200 = $16,400

4 Variable production overhead cost per unit = $(25,000 – 22,500) ÷ (10,000 – 7,500)
= $2,500 ÷ 2,500 = $1 per unit

 Fixed production overhead cost = $22,500 – (7,500 x $1) = $15,000

 Budget cost allowance = $15,000 + (8,200 x $1) = $23,200

5 Administration overhead is a fixed cost and hence budget cost allowance = $10,000

Comment

(a) In selling 8,200 units, the expected profit should have been not the fixed budget profit of $5,000,
but the flexible budget profit of $7,800. Instead actual profit was $8,200 ie $400 more than we
should have expected.

One of the reasons for this improvement is that, given output and sales of 8,200 units, the cost of
resources (material, labour etc) was $1,400 lower than expected.

In Paper P1 you saw how these total cost variances can be analysed to reveal how much of the
variance is due to lower resource prices and how much is due to efficient resource usage.

(b) The sales revenue was, however, $1,000 less than expected because a lower price was charged
than budgeted.
We know this because flexing the budget has eliminated the effect of changes in the volume sold,
which is the only other factor that can affect sales revenue. You have probably already realised
that this variance of $1,000 (A) is a selling price variance.
The lower selling price could have been caused by the increase in the volume sold (to sell the
additional 700 units the selling price had to fall below $10 per unit). We do not know if this is the
case, but without flexing the budget we could not know that a different selling price to that
budgeted had been charged. Our initial analysis above had appeared to indicate that sales revenue
was ahead of budget.
The difference of $400 between the flexible budget profit of $7,800 at a production level of 8,200 units
and the actual profit of $8,200 is due to the net effect of cost savings of $1,400 and lower than expected
sales revenue (by $1,000).
The difference between the original budgeted profit of $5,000 and the actual profit of $8,200 is the total
of the following.
(a) The savings in resource costs/lower than expected sales revenue (a net total of $400 as indicated
by the difference between the flexible budget and the actual results).
(b) The effect of producing and selling 8,200 units instead of 7,500 units (a gain of $2,800 as
indicated by the difference between the fixed budget and the flexible budget). This is the sales
volume contribution variance.
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A full variance analysis statement would be as follows.

$ $
Fixed budget profit 5,000
Variances
Sales volume 2,800 (F)
Selling price 1,000 (A)
Direct materials cost 1,100 (F)
Direct labour cost 900 (F)
Production overhead cost 400 (F)
Administration overhead cost 1,000 (A)
3,200 (F)
Actual profit 8,200

If management believes that any of the variances are large enough to justify it, they will investigate the
reasons for their occurrence to see whether any corrective action is necessary.

4.1 Flexible budgets, control and computers

The production of flexible budget control reports is an area in which computers can provide invaluable
assistance to the cost accountant, calculating flexed budget figures using fixed budget and actual results
data and hence providing detailed variance analysis. For control information to be of any value, it must be
produced quickly: speed is one of the many advantages of computers.

4.2 Flexible budgets using ABC data

Instead of flexing budgets according to the number of units produced or sold, in an ABC environment it is
possible to use more meaningful bases for flexing the budget. The budget cost allowance for each activity
can be determined according to the number of cost drivers.
Suppose the budget for a production department for a given period is as follows.
$
Wages 220,000
Materials 590,000
Equipment 20,000
Power, heat and light 11,000
841,000

This budget gives little indication of the link between the level of activity in the department and the costs
incurred, however.
Suppose the activities in the department have been identified as sawing, hammering, finishing, reworking
and production reporting. The budget might therefore be restated as follows.

Budgeted Budgeted
cost per unit no of cost
Activities Cost driver of cost driver drivers Budget
$ $
Sawing Number of units sawed 50.00 5,000 250,000
Hammering Number of units hammered together 10.00 35,000 350,000
Finishing Number of sq metres finished 0.50 400,000 200,000
Reworking Number of items reworked 12.40 2,500 31,000
Production
reporting Number of reports 400.00 25 10,000
841,000
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Advantages of this approach

(a) Costs classified as fixed in the first budget can now be seen to be variable and hence can be more
readily controlled.
(b) The implications of increases/decreases in levels of activity are immediately apparent. For example,
if acceptable quality levels were raised, requiring an additional 200 units per annum to be
reworked, budgeted costs would increase by 200  $12.40 = $2,480.

A flexible budget would be prepared as follows.

Actual no Budgeted cost

of cost per unit of
drivers cost driver Flexed budget Actual cost Variance
$ $ $ $
Sawing 6,000 50.00 300,000 297,000 3,000 (F)
Hammering 40,000 10.00 400,000 404,000 4,000 (A)
Finishing 264,400 0.50 132,200 113,200 19,000 (F)
Reworking 4,500 12.40 55,800 56,100 300 (A)
Production
reporting 30 400.00 12,000 13,700 1,700 (A)
900,000 884,000 16,000 (F)

4.3 The link between standard costing and budget flexing

The calculation of standard cost variances and the use of a flexed budget to control costs and revenues
are very similar in concept.

For example, a direct material total variance in a standard costing system is calculated by comparing the
material cost that should have been incurred for the output achieved, with the actual cost that was
incurred.

Exactly the same process is undertaken when a budget is flexed to provide a basis for comparison with
the actual cost: the flexible budget cost allowance for material cost is the same as the cost that should
have been incurred for the activity level achieved. In the same way as for standard costing, this is then
compared with the actual cost incurred in order to practice control by comparison.

However, there are differences between the two techniques.

(a) Standard costing variance analysis is more detailed. The total material cost variance is analysed
further to determine how much of the total variance is caused by a difference in the price paid for
materials (the material price variance) and how much is caused by the usage of material being
different from the standard (the material usage variance). In flexible budget comparisons only total
cost variances are derived.

(b) For a standard costing system to operate, it is necessary to determine a standard unit cost for all
items of output. All that is required to operate a flexible budgeting system is an understanding of
the cost behaviour patterns and a measure of activity to use to flex the budget cost allowance for
each cost element.

Section summary
Budgetary control is based around a system of budget centres. Each centre has its own budget which is
the responsibility of the budget holder.
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4.4 Budget control systems – key features

A BUDGET CENTRE is 'A section of an entity for which control may be exercised through budgets prepared'.

(CIMA Official Terminology)

KEY TERM

Budgetary control is based around a system of budget centres. Each budget centre will have its own budget
and a manager will be responsible for managing the budget centre and ensuring that the budget is met.

The selection of budget centres in an organisation is therefore a key first step in setting up a control
system. What should the budget centres be? What income, expenditure and/or capital employment plans
should each budget centre prepare? And how will measures of performance for each budget centre be
made?

A well-organised system of control should have the following features.

Feature Explanation
A hierarchy of budget centres If the organisation is quite large, a hierarchy is needed.
Subsidiary companies, departments and work sections might
be budget centres. Budgets of each section would then be
consolidated into a departmental budget, departmental
budgets in turn would be consolidated into the subsidiary's
budget and the budgets of each subsidiary would be
combined into a master budget for the group as a whole.
Clearly identified responsibilities for Individual managers should be made responsible for achieving
achieving budget targets the budget targets of a particular budget centre.
Responsibilities for revenues, costs Budget centres should be organised so that all the revenues
and capital employed earned by an organisation, all the costs it incurs and all the
capital it employs are made the responsibility of someone
within the organisation, at an appropriate level of authority in
the management hierarchy.

Budgetary control and budget centres are therefore part of the overall system of responsibility accounting
within an organisation.

4.5 The controllability principle SMA-Spring August 2014 (Q 4)

Care must be taken to distinguish between controllable costs and uncontrollable costs in variance
reporting. The controllability principle is that managers of responsibility centres should only be held
accountable for costs over which they have some influence. From a motivation point of view this is
important because it can be very demoralising for managers who feel that their performance is being
judged on the basis of something over which they have no influence. It is also important from a control
point of view, in that control reports should ensure that information on costs is reported to the manager
who is able to take action to control them.

4.6 Controllable and uncontrollable costs

A CONTROLLABLE COST is a 'Cost which can be controlled, typically by a cost, profit or investment centre
manager'.
KEY TERM (CIMA Official Terminology)

Responsibility accounting attempts to associate costs, revenues, assets and liabilities with the managers
most capable of controlling them. As a system of accounting, it therefore distinguishes between
controllable and uncontrollable costs.
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Most variable costs within a department are thought to be controllable in the short term because
managers can influence the efficiency with which resources are used, even if they cannot do anything to
raise or lower price levels.
A cost which is not controllable by a junior manager might be controllable by a senior manager. For example,
there may be high direct labour costs in a department caused by excessive overtime working. The junior
manager may feel obliged to continue with the overtime to meet production schedules, but his senior may be
able to reduce costs by hiring extra full-time staff, thereby reducing the requirements for overtime.
A cost which is not controllable by a manager in one department may be controllable by a manager in
another department. For example, an increase in material costs may be caused by buying at higher prices
than expected (controllable by the purchasing department) or by excessive wastage (controllable by the
production department) or by a faulty machine producing rejects (controllable by the maintenance
department).
Some costs are non-controllable, such as increases in expenditure items due to inflation. Other costs are
controllable, but in the long term rather than the short term. For example, production costs might be
reduced by the introduction of new machinery and technology, but in the short term, management must
attempt to do the best they can with the resources and machinery at their disposal.

4.6.1 The controllability of fixed costs

It is often assumed that all fixed costs are non-controllable in the short run. This is not so.
(a) Committed fixed costs are those costs arising from the possession of plant, equipment, buildings
and an administration department to support the long-term needs of the business. These costs
(depreciation, rent, administration salaries) are largely non-controllable in the short term because
they have been committed by longer-term decisions affecting longer-term needs. When a company
decides to cut production drastically, the long-term committed fixed costs will be reduced, but only
after redundancy terms have been settled and assets sold.
(b) A discretionary cost is a cost whose amount, within a particular time period, is determined by,
and can be altered by, the budget holder. Discretionary fixed costs, such as advertising and
research and development costs, are incurred as a result of a top management decision, but could
be raised or lowered at fairly short notice (irrespective of the actual volume of production and
sales).

4.6.2 Controllability and apportioned costs

Managers should only be held accountable for costs over which they have some influence. This may
seem quite straightforward in theory, but it is not always so easy in practice to distinguish controllable
from uncontrollable costs. Apportioned overhead costs provide a good example.

Example: Apportioned costs

Suppose that a manager of a production department in a manufacturing company is made responsible for
the costs of his department. These costs include directly attributable overhead items, such as the costs of
indirect labour employed and indirect materials consumed in the department. The department's overhead
costs also include an apportionment of costs from other cost centres, such as rent and rates for the building
it shares with other departments and a share of the costs of the maintenance department.

Should the production manager be held accountable for any of these apportioned costs?

Solution
(a) Managers should not be held accountable for costs over which they have no control. In this
example, apportioned rent and rates costs would not be controllable by the production department
manager.
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(b) Managers should be held accountable for costs over which they have some influence. In this
example, it is the responsibility of the maintenance department manager to keep maintenance
costs within budget, but their costs will be partly variable and partly fixed, and the variable cost
element will depend on the volume of demand for their services. If the production department's
staff treat their equipment badly, we might expect higher repair costs, and the production
department manager should therefore be made accountable for the repair costs that his
department makes the maintenance department incur on its behalf.

(c) Charging the production department with some of the costs of the maintenance department
prevents the production department from viewing the maintenance services as 'free services'. Over-
use would be discouraged and the production manager is more likely to question the activities of
the maintenance department, possibly resulting in a reduction in maintenance costs or the
provision of more efficient maintenance services.

4.6.3 Controllability and dual responsibility

Quite often a particular cost might be the responsibility of two or more managers. For example, raw
materials costs might be the responsibility of the purchasing manager (prices) and the production
manager (usage). A reporting system must allocate responsibility appropriately. The purchasing manager
must be responsible for any increase in raw materials prices, whereas the production manager should be
responsible for any increase in raw materials usage.

Exam skills
You can see that there are no clear-cut rules as to which costs are controllable and which are not. Each
situation and cost must be reviewed separately and a decision taken according to the control value of the
information and its behavioural impact.

4.7 Budgetary control reports

If the budget holders (managers of budget centres) are to attempt to meet budgets, they must receive
regular budgetary control reports so that they can monitor the budget centre's operations and take any
necessary control action.

The amount of detail included in reports will vary according to the needs of management. In general
terms, there should be sufficient detail within the reports to motivate the individual manager to take the
most appropriate action in all circumstances. A form of exception reporting can be used for top
management, reports just detailing significant variances.

Section summary
A budget centre is defined in CIMA Official Terminology as 'A section of an entity for which control may
be exercised through budgets prepared'.

Responsibility accounting is a system of accounting that segregates revenue and costs into areas of
personal responsibility in order to monitor and assess the performance of each part of an organisation.

Controllable costs are those which can be influenced by the budget holder. Uncontrollable costs cannot
be so influenced.
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5 Behavioural implications of budgeting

Introduction
Although the principal purpose of a budgetary control system is to assist in planning and control, it can
also have an effect on the behaviour of those directly affected by the budget. This section looks at how
budgets can affect employees’ behaviour and motivation.

5.1 Budgets and the provision of control information

The purpose of a budgetary control system is to assist management in planning and controlling the
resources of their organisation by providing appropriate control information. The information will only be
valuable, however, if it is interpreted correctly and used purposefully by managers and employees.

The correct use of control information therefore depends not only on the content of the information itself,
but also on the behaviour of its recipients. This is because control in business is exercised by people.
Their attitude to control information will colour their views on what they should do with it and a number
of behavioural problems can arise.

(a) The managers who set the budget or standards are often not the managers who are then made
responsible for achieving budget targets.

(b) The goals of the organisation as a whole, as expressed in a budget, may not coincide with the
personal aspirations of individual managers.

(c) Control is applied at different stages by different people. A supervisor might get weekly control
reports, and act on them; his superior might get monthly control reports, and decide to take
different control action. Different managers can get in each others' way, and resent the interference
from others.

5.2 Motivation
Motivation is what makes people behave in the way that they do. It comes from individual attitudes or
group attitudes. Individuals will be motivated by personal desires and interests. These may be in line
with the objectives of the organisation, and some people 'live for their jobs'. Other individuals see their job
as a chore, and their motivations will be unrelated to the objectives of the organisation they work for.

It is therefore vital that the goals of management and the employees harmonise with the goals of the
organisation as a whole. This is known as goal congruence. Although obtaining goal congruence is
essentially a behavioural problem, it is possible to design and run a budgetary control system which will
go some way towards ensuring that goal congruence is achieved. Managers and employees must
therefore be favourably disposed towards the budgetary control system so that it can operate efficiently.

The management accountant should therefore try to ensure that employees have positive attitudes
towards setting budgets, implementing budgets (that is, putting the organisation's plans into practice)
and feedback of results (control information).

5.2.1 Poor attitudes when setting budgets

If managers are involved in preparing a budget, poor attitudes or hostile behaviour towards the budgetary
control system can begin at the planning stage.

(a) Managers may complain that they are too busy to spend much time on budgeting.

(b) They may build 'slack' into their expenditure estimates.

(c) They may argue that formalising a budget plan on paper is too restricting and that managers
should be allowed flexibility in the decisions they take.
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(d) They may set budgets for their budget centre and not co-ordinate their own plans with those of
other budget centres.

(e) They may base future plans on past results, instead of using the opportunity for formalised
planning to look at alternative options and new ideas.

On the other hand, managers may not be involved in the budgeting process. Organisational goals may
not be communicated to them and they might have their budget decided for them by senior management
or administrative decision. It is hard for people to be motivated to achieve targets set by someone else.

5.2.2 Poor attitudes when putting plans into action

Poor attitudes also arise when a budget is implemented.
(a) Managers might put in only just enough effort to achieve budget targets, without trying to beat
targets.
(b) A formal budget might encourage rigidity and discourage flexibility.
(c) Short-term planning in a budget can draw attention away from the longer-term consequences of
decisions.
(d) There might be minimal co-operation and communication between managers.
(e) Managers will often try to make sure that they spend up to their full budget allowance, and do not
overspend, so that they will not be accused of having asked for too much spending allowance in
the first place.
(f) Particularly in service departments and public sector organisations, where performance is
assessed by comparing actual and budget spending, managers may consider the budget as a sum
of money that has to be spent. A manager of a local authority department might be given an
annual budget of $360,000. The manager knows that he will be punished for spending more than
$360,000 but that if he spends less than $300,000 his budget will probably be reduced next
year, leading to a loss of status and making his job more difficult next year. To ensure he does not
overspend, he may spend $26,000 a month for 11 months of the year (by reducing the provision
of the department's service), building up a contingency fund of (11  $4,000) $44,000 to be used
in case of emergencies. In the final month of the year he would then need to spend ($(44,000 +
30,000)) $74,000 to ensure his whole budget was used (perhaps by using extra labour and/or
high quality materials). The manager's behaviour has therefore been distorted by the control
system.

5.2.3 Poor attitudes and the use of control information

The attitude of managers towards the accounting control information they receive might reduce the
information's effectiveness.
(a) Management accounting control reports could well be seen as having a relatively low priority in the
list of management tasks. Managers might take the view that they have more pressing jobs on
hand than looking at routine control reports.
(b) Managers might resent control information; they may see it as part of a system of trying to find
fault with their work. This resentment is likely to be particularly strong when budgets or standards
are imposed on managers without allowing them to participate in the budget-setting process.
(c) If budgets are seen as pressure devices to push managers into doing better, control reports will be
resented.
(d) Managers may not understand the information in the control reports, because they are unfamiliar
with accounting terminology or principles.
(e) Managers might have a false sense of what their objectives should be. A production manager
might consider it more important to maintain quality standards regardless of cost. He would then
dismiss adverse expenditure variances as inevitable and unavoidable.
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(f) If there are flaws in the system of recording actual costs, managers will dismiss control
information as unreliable.
(g) Control information might be received weeks after the end of the period to which it relates, in
which case managers might regard it as out of date and no longer useful.
(h) Managers might be held responsible for variances outside their control.
It is therefore obvious that accountants and senior management should try to implement systems that are
acceptable to budget holders and which produce positive effects.

5.2.4 Pay as a motivator

Many researchers agree that pay can be an important motivator, when there is a formal link between higher
pay (or other rewards, such as promotion) and achieving budget targets. Individuals are likely to work harder to
achieve budget if they know that they will be rewarded for their successful efforts. There are, however,
problems with using pay as an incentive.

(a) A serious problem that can arise is that formal reward and performance evaluation systems can
encourage dysfunctional behaviour. Many investigations have noted the tendency of managers to
pad their budgets either in anticipation of cuts by superiors or to make the subsequent variances
more favourable. And there are numerous examples of managers making decisions in response to
performance indices, even though the decisions are contrary to the wider purposes of the
organisation.

(b) The targets must be challenging, but fair, otherwise individuals will become dissatisfied. Pay can
be a demotivator as well as a motivator!

Section summary
Used correctly a budgetary control system can motivate, but it can also produce undesirable negative
reactions.

6 Budget participation

Introduction
It has been argued that participation in the budgeting process will improve motivation and so will
improve the quality of budget decisions and the efforts of individuals to achieve their budget targets. This
section looks at different budget styles and how they affect the participation process.

There are basically two ways in which a budget can be set: from the TOP DOWN (imposed budget) or from
the BOTTOM UP (participatory budget).
KEY TERM

6.1 Imposed style of budgeting

An IMPOSED/TOP-DOWN BUDGET is a 'Budgeting process where budget allowances are set without
permitting the ultimate budget holders to have the opportunity to participate in the budgeting process'.
KEY TERM (CIMA Official Terminology)

In this approach to budgeting, top management prepare a budget with little or no input from operating
personnel, which is then imposed upon the employees who have to work to the budgeted figures.
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The times when imposed budgets are effective:

 In newly formed organisations

 In very small businesses
 During periods of economic hardship
 When operational managers lack budgeting skills
 When the organisation's different units require precise co-ordination

There are, of course, advantages and disadvantages to this style of setting budgets.

(a) Advantages

(i) Strategic plans are likely to be incorporated into planned activities.

(ii) They enhance the co-ordination between the plans and objectives of divisions.
(iii) They use senior management's awareness of total resource availability.
(iv) They decrease the input from inexperienced or uninformed lower-level employees.
(v) They decrease the period of time taken to draw up the budgets.

(b) Disadvantages

(i) There is dissatisfaction, defensiveness and low morale amongst employees. It is hard for
people to be motivated to achieve targets set by somebody else.

(ii) The feeling of team spirit may disappear.

(iii) The acceptance of organisational goals and objectives could be limited.

(iv) The feeling of the budget as a punitive device could arise.

(v) Managers who are performing operations on a day-to-day basis are likely to have a better
understanding of what is achievable.

(vi) Unachievable budgets could result if consideration is not given to local operating and
political environments. This applies particularly to overseas divisions.

(vii) Lower-level management initiative may be stifled.

6.2 Participative style of budgeting

PARTICIPATIVE/BOTTOM-UP BUDGETING is a 'Budgeting process where all budget holders have the
opportunity to participate in setting their own budgets'.
(CIMA Official Terminology)
KEY TERM
In this approach to budgeting, budgets are developed by lower-level managers who then submit the
budgets to their superiors. The budgets are based on the lower-level managers' perceptions of what is
achievable and the associated necessary resources.

Question 5.2 Participative budgets

Learning outcome B2(c)

In what circumstances might participative budgets not be effective?

A In centralised organisations
B In well-established organisations
C In very large businesses
D During periods of economic affluence
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Advantages of participative budgets

 They are based on information from employees most familiar with the department.
 Knowledge spread among several levels of management is pulled together.
 Morale and motivation is improved.
 They increase operational managers' commitment to organisational objectives.
 In general they are more realistic.
 Co-ordination between units is improved.
 Specific resource requirements are included.
 Senior managers' overview is mixed with operational-level details.
 Individual managers' aspiration levels are more likely to be taken into account.

Disadvantages of participative budgets

 They consume more time.

 Changes implemented by senior management may cause dissatisfaction.
 Budgets may be unachievable if managers are not qualified to participate.
 They may cause managers to introduce budgetary slack and budget bias.
 They can support 'empire building' by subordinates.
 An earlier start to the budgeting process could be required.
 Managers may set 'easy' budgets to ensure that they are achievable.

6.3 Negotiated style of budgeting

A NEGOTIATED BUDGET is a 'Budget in which budget allowances are set largely on the basis of negotiations
between budget holders and those to whom they report'. (CIMA Official Terminology)
KEY TERM
At the two extremes, budgets can be dictated from above or simply emerge from below but, in practice,
different levels of management often agree budgets by a process of negotiation. In the imposed budget
approach, operational managers will try to negotiate with senior managers the budget targets that they
consider to be unreasonable or unrealistic. Likewise, senior management usually review and revise
budgets presented to them under a participative approach through a process of negotiation with lower-
level managers. Final budgets are therefore most likely to lie between what top management would
really like and what junior managers believe is feasible. The budgeting process is hence a bargaining
process and it is this bargaining which is of vital importance, determining whether the budget is an
effective management tool or simply a clerical device.

6.4 Budget slack

BUDGET SLACK is the 'Intentional overestimation of expenses and/or underestimation of revenues during
the budget setting'. (CIMA Official Terminology)
KEY TERM
In the process of preparing budgets, managers might deliberately overestimate costs and underestimate
sales, so that they will not be blamed in the future for overspending and poor results.

In controlling actual operations, managers must then ensure that their spending rises to meet their
budget, otherwise they will be 'blamed' for careless budgeting.

Budget bias can work in the other direction, too. It has been noted that, after a run of mediocre results,
some managers deliberately overstate revenues and understate cost estimates, no doubt feeling the need
to make an immediate favourable impact by promising better performance in the future. They may merely
delay problems, however, as the managers may well be censured when they fail to hit these optimistic
targets.

Yet again, this is an example of control systems distorting the processes they are meant to serve.
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Section summary
There are basically two ways in which a budget can be set: from the top down (imposed budget) or from
the bottom up (participatory budget). Many writers refer to a third style (negotiated).

Budget slack occurs when managers deliberately underestimate sales or overestimate costs to avoid being
blamed for future poor results.

7 The use of budgets as targets

Introduction
Once decided, budgets become targets. As targets, they can motivate managers to achieve a high level of
performance. This section looks at the extent to which managers can be motivated by budget targets and
the challenges of ensuring the correct level of difficulty of these targets.

7.1 Setting the target

(a) There is likely to be a demotivating effect where an ideal standard of performance is set, because
adverse efficiency variances will always be reported.

(b) A low standard of efficiency is also demotivating, because there is no sense of achievement in
attaining the required standards, and there will be no impetus for employees to try harder to do
better than this.

(c) A budgeted level of attainment could be 'normal': that is, the same as the level that has been
achieved in the past. Arguably, this level will be too low. It might encourage budgetary slack.

7.2 Aspiration levels

It has been argued that each individual has a personal 'aspiration level'. This is a level of performance in
a task with which the individual is familiar, which the individual undertakes for himself to reach. This
aspiration level might be quite challenging and, if individuals in a work group all have similar aspiration
levels, it should be possible to incorporate these levels within the official operating standards.

Some care should be taken, however, in applying this.

(a) If a manager's tendency to achieve success is stronger than the tendency to avoid failure,
budgets with targets of intermediate levels of difficulty are the most motivating and stimulate a
manager to better performance levels. Budgets which are either too easy to achieve or too difficult
are demotivating, and managers given such targets achieve relatively low levels of performance.

(b) A manager's tendency to avoid failure might be stronger than the tendency to achieve success.
(This is likely in an organisation in which the budget is used as a pressure device on subordinates
by senior managers.) Managers might then be discouraged from trying to achieve budgets of
intermediate difficulty and tend to avoid taking on such tasks, resulting in poor levels of
performance, worse than if budget targets were either easy or very difficult to achieve.

7.3 A case for two budgets?

It has been suggested that in a situation where budget targets of an intermediate difficulty are motivating,
such targets ought to be set if the purpose of budgets is to motivate. However, although budgets which
are set for motivational purposes need to be stated in terms of aspirations rather than expectations,
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budgets for planning and decision purposes need to be stated in terms of the best available estimate of
expected actual performance. The solution might therefore be to have two budgets:

(a) A budget for planning and decision-making based on reasonable expectations

(b) A second budget for motivational purposes, with more difficult targets of performance (that is,
targets of an intermediate level of difficulty)

These two budgets might be called an 'expectations budget' and an 'aspirations budget' respectively.

Section summary
In certain situations it is useful to prepare an expectations budget (for planning and decision-making
purposes) and an aspirations budget (to act as a motivational tool).

8 Budgets and motivation

Introduction
We have seen that budgets serve many purposes, but in some instances their purposes can conflict and
have an effect on management behaviour. This section examines the need for strategies and methods to
deal with the resulting tensions and conflict.

8.1 Is motivation from budgets ever possible?

Can performance measures and the related budgetary control system ever motivate managers towards
achieving the organisation's goals?

(a) Accounting measures of performance can't provide a comprehensive assessment of what a person
has achieved for the organisation.

(b) It is unfair as it is usually impossible to segregate controllable and uncontrollable components of

performance.

(c) Accounting reports tend to concentrate on short-term achievements, to the exclusion of the
long-term effects.

(d) Many accounting reports try to serve several different purposes, and in trying to satisfy several
needs actually satisfy none properly.

8.2 Support from senior management

The management accountant does not have the authority to do much on his or her own to improve hostile
or apathetic attitudes to control information. There has to be support, either from senior management or
from budget centre managers.

(a) How senior management can offer support:

(i) Making sure that a system of responsibility accounting is adopted

(ii) Allowing managers to have a say in formulating their budgets
(iii) Offering incentives to managers who meet budget targets
(iv) Not regarding budgetary control information as a way of apportioning blame

(b) Budget centre managers should accept their responsibilities. In-house training courses could be
held to encourage a collective, co-operative and positive attitude among managers.
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8.3 Support from the management accountant

The management accountant can offer support in the following ways.

(a) Develop a working relationship with operational managers, going out to meet them and
discussing the control reports.

(b) Explain the meaning of budgets and control reports.

(c) Keep accounting jargon in these reports to a minimum.

(d) Make reports clear and to the point, for example using the principle of reporting by exception.

(e) Provide control information with a minimum of delay.

(f) Make control information as useful as possible, by distinguishing between directly attributable and
controllable costs, over which a manager should have influence, and apportioned or fixed costs,
which are unavoidable or uncontrollable.

(g) Make sure that actual costs are recorded accurately.

(h) Ensure that budgets are up to date, either by having a system of rolling budgets, or else by
updating budgets or standards as necessary, and ensuring that standards are 'fair' so that control
information is realistic.

Question 5.3 Behavioural aspects of budget participation

Learning outcome B2(c)

Discuss the behavioural aspects of participation in the budgeting process and any difficulties you might
envisage.

Section summary
There are no ideal solutions to the conflicts caused by the operation of a budgetary control system.
Management and the management accountant have to develop their own ways of dealing with them,
taking into account their organisation, their business and the personalities involved.

9 Beyond budgeting

Introduction
This section looks at the arguments put forward by the Beyond Budgeting Round Table that traditional
budgeting should be abandoned.

9.1 Criticisms of budgeting

In our discussion of the budgetary planning process, we have come across many difficulties with budgets
and criticisms of how they are used in organisations. The discussion on behavioural issues in this chapter
should help you to appreciate the real danger that budgets can cause unintended dysfunctional behaviour
that needs to be guarded against in organisations.

The Beyond Budgeting Round Table (BBRT), an independent research collaborative, propose that
budgeting, as most organisations practise it, should be abandoned. Their website at [Link] lists
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the following ten criticisms of budgeting as put forward by Hope and Fraser Beyond Budgeting (1st
edition, Harvard Business School Press, 2003).

(a) Budgets are time-consuming and expensive. Even with the support of computer models it is
estimated that the budgeting process uses up to 20% to 30% of senior executives’ and financial
managers’ time.

(b) Budgets provide poor value to users. Although surveys have shown that some managers feel that
budgets give them control, a large majority of financial directors wish to reform the budgetary
process because they feel that finance staff spend too much time on 'lower value added activities'.

(c) Budgets fail to focus on shareholder value. Most budgets are set on an incremental basis as an
acceptable target agreed between the manager and the manager’s superior. Managers may be
rewarded for achieving their short-term budgets and will not look to the longer term or take risks,
for fear of affecting their own short-term results.

(d) Budgets are too rigid and prevent fast response. Although most organisations do update and
revise their budgets at regular intervals as the budget period proceeds, the process is often too
slow compared with the pace at which the external environment is changing.

(e) Budgets protect rather than reduce costs. Once a manager has an authorised budget, he can
spend that amount of resource without further authorisation. A ‘use it or lose it’ mentality often
develops, so that managers will incur cost unnecessarily. This happens especially towards the end
of the budget period in the expectation that managers will not be permitted to carry forward any
unused resource into the budget for next period.

(f) Budgets stifle product and strategy innovation. The focus on achieving the budget discourages
managers from taking risks in case this has adverse effects on their short-term performance.
Managers do not have the freedom to respond to changing customer needs in a fast-changing
market because the activity they would need to undertake is not authorised in their budget.

(g) Budgets focus on sales targets rather than customer satisfaction. The achievement of short-term
sales forecasts becomes the focus of most organisations. However, this does not necessarily result
in customer satisfaction. The customer may be sold something inappropriate to their needs, as in
recent years in the UK financial services industry. Alternatively, if a manager has already met the
sales target for a particular period, they might try to delay sales to the next period, in order to give
themselves a ‘head start’ towards achieving the target for the next period. Furthermore, there is an
incentive towards the end of a period, if a manager feels that the sales target is not going to be
achieved for the period, to delay sales until the next period, and thus again have a head start
towards achieving the target for the next period. All of these actions, focusing on sales targets
rather than customer satisfaction, will have a detrimental effect on the organisation in the longer
term.

(h) Budgets are divorced from strategy. Most organisations monitor the monthly results against the
short-term budget for the month. What is needed instead is a system of monitoring the longer term
progress against the organisation’s strategy.

(i) Budgets reinforce a dependency culture. The process of planning and budgeting within a
framework devolved from senior management perpetuates a culture of dependency. Traditional
budgeting systems, operated on a centralised basis, do not encourage a culture of personal
responsibility.

(j) Budgets lead to unethical behaviour. For example we have seen in this chapter a number of
opportunities for dysfunctional behaviour, such as building slack into the budget in order to create
an easier target for achievement.
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9.2 Beyond budgeting (BB) concepts

Two fundamental concepts underlie the beyond budgeting (BB) approach.

(a) Use adaptive management processes rather than the more rigid annual budget. Traditional
annual plans tie managers to predetermined actions which are not responsive to current situations.
Managers should instead be planning on a more adaptive, rolling basis, but with the focus on cash
forecasting rather than purely on cost control. Performance is monitored against world-class
benchmarks, competitors and previous periods.

(b) Move towards devolved networks rather than centralised hierarchies. The emphasis is on
encouraging a culture of personal responsibility by delegating decision making and performance
accountability to line managers.

Beyond Budgeting model

Adapted from [Link]

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9.3 Adaptive management processes

An adaptive management process does not tie a manager to the achievement of a fixed target but
instead expects managers to deliver continuous performance improvement in response to changing
conditions. Planning is undertaken on a continuous, participative basis.

Evaluation of a manager’s performance is based on relative improvement and this evaluation is carried
out using a range of relative performance indicators with hindsight, ie taking account of the conditions
under which the manager was operating.

Managers are given the resources they need as they are required and horizontal cross-company activities
are co-ordinated to respond to customer demand.

9.4 Devolved organisations

In a devolved organisation, managers are enabled and encouraged to make their own local decisions in
order to achieve results, within a governance framework based on clear principles and boundaries.
Managers are not restricted to a specific agreed plan but can use their own initiative and local knowledge
to achieve the organisation’s goals. They are expected to make decisions that create value and are fully
accountable for customer satisfaction and for achieving a high level of relative success.

The emphasis in information systems is on openness and ‘one truth’ throughout the organisation, thus
encouraging ethical behaviour that is beneficial to the organisation.

The ability of managers to act immediately, without the restriction of a fixed plan, but with clear
principles and values and within strategic boundaries enables the organisation to respond quickly to
identified opportunities and threats.

9.5 BB implementation
A BB implementation should incorporate the following six main principles.

(a) The responsibilities of managers within an organisation should be clearly defined.

(b) Managers should be given goals and targets which are based on key performance indicators and
benchmarks. These targets should be linked to shareholder value.

(c) Managers should be given a degree of freedom to make decisions. A BB organisation chart should
be 'flat'.

(d) Responsibility for decisions that generate value should be placed with 'front line teams' in line with
the concept of TQM.

(e) Front line teams should be made responsible for relationships with customers, associate
businesses and suppliers.

(f) Information support systems should be transparent and align with the activities that managers are
responsible for.

Question 5.4 In defence of traditional budgeting

Learning outcome B2(c)

Identify THREE criticisms that are levelled at the traditional budgeting process by advocates of techniques
that are ‘beyond budgeting’ and explain how the traditional budgeting process can be adapted to address
these criticisms.
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Section summary
The Beyond Budgeting Round Table, an independent research collaborative, have proposed that
traditional budgeting should be abandoned. They have published ten main criticisms of the traditional
process.

The two fundamental concepts of the BB approach are the use of adaptive management processes rather
than fixed annual budgets and a move to a more decentralised way of managing the business with a
culture of personal responsibility.
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Chapter Summary

Decision making in
responsibility centres

Cost, profit and investment Performance reports Budgeting

centres

• Controllable vs
Uncontrollable costs
• Budget flexing Cost Behavioural aspects of
centre budgeting

• Original • Participation vs top

• Flexed down
• Actual • Budget padding and
• Variance manipulation
• Setting targets for
motivation
• Implications of setting
standard costs
Profit
centre
Beyond budgeting
• Budget
• Actual
• Variance • Move away from
traditional budgeting
• Cash flow forecasts and
KPIs used instead
• KPIs referenced to
external items
• Employee
empowerment enables
decisions to be taken
quickly
• Rewards are team
based
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Quick Quiz
1 Fill in the blanks.

A flexible budget is a budget which, by recognising ……………………………., is designed

to……………………………. as the level of activity changes.

2 An extract of the costs incurred at two different activity levels is shown. Classify the costs according to
their behaviour patterns and show the budget cost allowance for an activity of 1,500 units.

Budget cost allowance

1,000 2,000 units Type of cost for 1,500 units
units
$ $ $
(a) Fuel 3,000 6,000 ……………………. ………………………….
(b) Photocopying 9,500 11,000 ……………………. ………………………….
(c) Heating 2,400 2,400 ……………………. ………………………….
(d) Direct wages 6,000 8,000 ……………………. ………………………….

3 What is the controllability principle?

4 Match the descriptions to the budgeting style.

Description

(a) Budget allowances are set without the involvement of the budget holder

(b) All budget holders are involved in setting their own budgets

(c) Budget allowances are set on the basis of discussions between budget holders and those to whom
they report

Budgeting style

Negotiated budgeting
Participative budgeting
Imposed budgeting

5 Choose the appropriate words from those highlighted.

An expectations/aspirations budget would be most useful for the purposes of planning and decision
making based on reasonable expectations, whereas an aspirations/expectations budget is more
appropriate for improving motivation by setting targets of an intermediate level of difficulty.

6 In the context of a balanced scorecard approach to performance measurement, to which of the four
perspectives does each measure relate?

Performance measure Perspective

(a) Time taken to develop new products …………………….

(b) Percentage of on-time deliveries …………………….

(c) Average set-up time …………………….

(d) Return on capital employed …………………….

7 Choose the appropriate words from those highlighted.

The correct approach to budgetary control is to compare actual/budgeted results with a budget that has
been flexed to the actual/budgeted level of activity.

8 Not all fixed costs are non-controllable in the short term. True or false?
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9 What is goal congruence (in terms of organisational control systems)?

A When the goals of management and employees harmonise with the goals of the organisation as a
whole

B When the goals of management harmonise with the goals of employees

C When the work-related goals of management harmonise with their personal goals

D When an organisation's goals harmonise with those of its customers

10 For each organisation there is an ideal solution to the conflicts caused by the operation of a budgetary
control system and it is the responsibility of the management accountant to find that solution. True or
false?

11 Which of the following is not consistent with the concepts of the Beyond Budgeting approach?

A Continuous forecasting
B Participative planning
C Centralised decision making
D Relative performance measures

12 Which of the following definitions is/are correct?

1 An imposed budget is a budget which, by recognising different cost behaviour patterns, is designed
to change as the volume of activity changes

2 Bottom-up budgeting is a process where all budget holders have the opportunity to participate

A Neither are correct

B Definition 1 only is correct
C Definition 2 only is correct
D Both definitions are correct
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Answers to Quick Quiz

1 cost behaviour patterns

flex or change

2 (a) Variable $4,500

(b) Semi-variable $10,250
(c) Fixed $2,400
(d) Semi-variable $7,000

3 The principle that managers should only be held responsible for costs that they have direct control over.

4 (a) Imposed budgeting

(b) Participative budgeting
(c) Negotiated budgeting

5 expectations
aspirations

6 (a) Learning
(b) Customer
(c) Internal
(d) Financial

7 actual
actual

8 True. Discretionary fixed costs can be raised or lowered at fairly short notice.

9 A

10 False. There are no ideal solutions. Management and the management accountant have to develop their
own ways of dealing with the conflicts, taking into account the organisation, the business and the
personalities involved.

11 C

12 C Definition 1 refers to a flexible budget.

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Answers to Questions

5.1 Responsibility accounting

In a system of responsibility accounting costs and revenues are segregated into areas of personal responsibility
in order to monitor and assess the performance of each part of an organisation.

Controllable costs are those costs which are within the control of the manager of a responsibility centre, whereas
uncontrollable costs are outside the control of the centre manager.

A budget cost allowance is the cost that should be incurred in a responsibility centre for the actual activity level
that was achieved. It is the flexible budget cost that is obtained by flexing the variable cost allowance in line
with changes in the level of activity.

All three items are important from the point of view of control and motivation.

Better cost control is achieved if those areas that a manager can control (controllable costs) are highlighted
separately from those costs that the manger cannot control (uncontrollable costs). Better cost control is also
achieved through more meaningful variances that are obtained by comparing a realistic flexible budget cost
allowance with the actual results that were achieved.

Motivation of managers is improved if uncontrollable items are analysed separately, since otherwise they will feel
they are being held accountable for something over which they have no control. Similarly, the realistic flexible
budget of comparison is more likely to have a positive motivational impact because a more meaningful
comparative measure of actual performance is obtained.

5.2 Participative budgets

A participative budget is likely to be least effective in a centralised organisation. An imposed budget will be
more effective in such an organisation.

5.3 Behavioural aspects of budget participation

The level of participation in the budgeting process can vary from zero participation to a process of group decision
making. There are a number of behavioural aspects of participation to consider.

(a) Communication. Managers cannot be expected to achieve targets if they do not know what those targets
are. Communication of targets is made easier if managers have participated in the budgetary process from
the beginning.

(b) Motivation. Managers are likely to be better motivated to achieve a budget if they have been involved in
compiling it, rather than having a dictatorial budget imposed on them.

(c) Realistic targets. A target must be achievable and accepted as realistic if it is to be a motivating factor. A
manager who has been involved in setting targets is more likely to accept them as realistic. In addition,
managers who are close to the operation of their departments may be more aware of the costs and
potential savings in running it.

(d) Goal congruence. One of the best ways of achieving goal congruence is to involve managers in the
preparation of their own budgets, so that their personal goals can be taken into account in setting targets.

Although participative budgeting has many advantages, difficulties might also arise.

(e) Pseudo-participation. Participation may not be genuine, but merely a pretence at involving managers in
the preparation of their budgets. Managers may feel that their contribution is being ignored, or that the
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participation consists of merely obtaining their agreement to a budget which has already been decided. If
this is the case, then managers are likely to be more demotivated than if there is no participation at all.

(f) Co-ordination. If participative budgeting is well managed it can improve the co-ordination of the
preparation of the various budgets. There is, however, a danger that too many managers will become
involved so that communication becomes difficult and the process complex.

(g) Training. Some managers may not possess the necessary skill to make an effective contribution to the
preparation of their budgets. Additional training may be necessary, with the consequent investment of
money and time. It may also be necessary to train managers to understand the purposes and advantages
of participation.

(h) Slack. If budgets are used in a punitive fashion for control purposes, then managers will be tempted to
build in extra expenditure to provide a 'cushion' against overspending. It is easier for them to build in slack
in a participative system.

5.4 In defence of traditional budgeting

Three criticisms that could be addressed by adapting the traditional budgeting process are as follows.

(a) Budgets are time consuming and expensive.

(b) Budgets protect rather than reduce costs.
(c) Budgets focus on sales targets rather than customer satisfaction.

The traditional budgeting process can be operated in a fashion that addresses these criticisms as follows.

(a) Budgets are time consuming and expensive

A traditional budgeting system need not be more expensive and time consuming than the adaptive
management process advocated as a 'beyond budgeting' concept. Managers need to appreciate that the
cost of obtaining information should not exceed the benefit to be derived from it. A culture of ‘sufficiently
accurate’ should be encouraged in budget managers and they should understand that their task is to
quantify the costs to be incurred in their area in order to achieve the organisation’s strategy. This does
not necessitate a separate forecast for every paperclip and staple, down to the nearest penny, but budgets
can instead be prepared to the nearest thousand or to the nearest million, depending on the size of the
organisation.

(b) Budgets protect rather than reduce costs

The attitude of senior managers needs to change in order to prevent unnecessary expenditure and slack
being built into the budget. If a budget manager has not used all of their allocated budget resource during
a period, they should not expect to lose that resource in the next period. Each manager should be able to
request the resource needed to achieve the organisation’s strategy, regardless of the expenditure
incurred in the latest period or the amount that was included in the original budget. Thus a ‘use it or lose
it’ culture can be avoided.

Slack can also be avoided by using budgetary control reports in a less punitive and rigid manner. If
managers believe they are going to be admonished for exceeding the budget expenditure or they are not
going to be allowed more resource than stated in their original budget, then they will build in slack at the
planning stage in order to provide some leeway.

(c) Budgets focus on sales targets rather than customer satisfaction

The punitive use of budgetary control reports will again aggravate this situation. Managers must be given
the opportunity to justify any sales shortfalls and should not be penalised for any shortfalls that are
beyond their control. The use of non-financial performance measures combined with the financial
budgetary control reports will assist in moving managers’ focus away from the sales targets. For example,
managers’ performance could be assessed on a combination of sales targets and the level of customer
satisfaction achieved.
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Now try these questions from Number Marks Time

the Practice Question Bank
Q19 Objective test questions 10 18 mins
Q20 Responsibility accounting 5 9 mins
Q21 Budgets and people 12 22 mins
Q22 Divisional performance 15 27 mins
Q23 B and C 30 54 mins
Q24 Pasta division 30 54 mins
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