# Budgetary Control and Variance Analysis

## Budgetary Control and Variance Analysis

### Budgetary Control and Variance Analysis

Chapter 15 Budgeting and Standard Costing

1.      Objectives

1.1       Explain the use of standard costs.
1.2       Outline the methods used to derive standard costs and discuss the different types of cost possible.
1.3       Explain and apply the principle of controllability in the performance management system.

2.      The Use of Standard Costs

 2.1 The use of standard costs Two principle uses: (a)       To value inventories and cost production for cost accounting purposes. It is an alternative method of valuation to methods like FIFO and LIFO. (b)       To act as a control device by establishing standards (expected costs) and comparing actual costs with the expected costs, thus highlighting areas of the organizations which may be out of control. Other uses: (c)       To assist in setting budgets and evaluating managerial performance. (d)       To enable the principle of 'management by exception' to be practised. A standard cost, when established, is an average expected unit cost. Because it is only an average, actual results will vary to some extent above and below the average. Only significant differences between actual and standard should be reported. (e)       To provide a prediction of future costs to be used in decision-making situations. (f)       To motivate staff and management by the provision of challenging targets. (g)       To provide guidance on possible ways of improving efficiency.

2.2       Where standard costing should be used

2.2.1    Although standard costing can be used in a variety of costing situations (batch and mass production, process manufacture, jobbing manufacture (where there is standardisation of parts) and service industries (if a realistic cost unit can be established)), the greatest benefit from its use can be gained if there is a degree of repetition in the production process so that average or expected usage of resources can be determined. It is therefore most suited to mass production and repetitive assembly work and less suited to organisations which produce to customer demand and requirements.

3.      Types of Standard

 3.1 Types of standard (a)       An ideal standard is a standard which can be attained under perfect operating conditions: no wastage, no inefficiencies, no idle time, no breakdowns. Ideal standards can be seen as long-term targets but are not very useful for day-to-day control purposes. Ideal standards cannot be achieved. If such standards are used for budgeting, an allowance will have to be included to make the budget realistic and attainable. (b)       An attainable standard is a standard which can be attained if production is carried out efficiently, machines are properly operated and/or materials are properly used. Some allowance is made for wastage and inefficiencies. Attainable standards can be used for product costing, cost control, inventory valuation, estimating and as a basis for budgeting. (c)       A current standard is standard based on current working conditions (current wastage, current inefficiencies). Current standards or attainable standards provide the best basis for budgeting, because they represent an achievable level of productivity. Current standards do not attempt to improve on current levels of efficiency. Current standards are useful during periods when inflation is high. They can be set on a month by month basis. (d)       A basic standard is a long-term standard which remains unchanged over the years and is used to show trends. Basic standards are used to show changes in efficiency or performance over a long period of time. They are perhaps the least useful and least common type of standard in use.

4.      Budgets and Standards Compared

4.1       Budgets and standards are similar in the following ways.
(a)        They both involve looking to the future and forecasting what is likely to happen given a certain set of circumstances.
(b)       They are both used for control purposes. A budget aids control by setting financial targets or limits for a forthcoming period. Actual achievements or expenditures are then compared with the budgets and action is taken to correct any variances where necessary. A standard also achieves control by comparison of actual results against a predetermined target.
4.2       As well as being similar, budgets and standards are interrelated. For example, a standard unit production cost can act as the basis for a production cost budget. The unit cost is multiplied by the budgeted activity level to arrive at the budgeted expenditure on production costs.
4.3       There are, however, important differences between budgets and standards.

 Budgets Standards Gives planned total aggregate costs for a function or cost centre. Shows the unit resource usage for a single task, for example, the standard labour hours for a single unit of production. Can be prepared for all functions, even where output cannot be measured. Limited to situations where repetitive actions are performed and output can be measured. Expressed in money terms. Need not be expressed in money terms. For example, a standard rate of output does not need a financial value put on it.

5.      The Principle of Controllability

5.1       The principle of controllability is that managers of responsibility centres should only be held accountable for cost over which they have some influence.

5.2       Budget centres

5.2.1    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.
5.2.2    A well-orgainsed 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 achieving budget targets Individual managers should be made responsible for achieving the budget targets of a particular budget centre. Responsibilities for revenues, costs and capital employed Budget centres should be organised so that all the revenues 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.

5.2.3    Budgetary control and budget centres are therefore part of the overall system of responsibility accounting within an organization.
5.2.4    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.

5.3       Controllable costs

5.3.1    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.
5.3.2    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.
5.3.3    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.
5.3.4    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.
5.3.5    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.
5.3.6    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.

5.4       Controllability and apportioned costs

5.4.1    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.
5.4.2    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.
5.4.3    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.

5.5       Controllability and dual responsibility

5.5.1    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.

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#### Budgetary Control and Variance Analysis

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##### Budgetary Control and Variance Analysis

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