Accounting in

Organisations and Society

Module 2 – Accounting and its role in managerial activities
Topic 3: Performance measurement budgeting

Topic Notes

Topic 3: Performance measurement budgeting

RMIT University
Accounting and its role in managerial activities
Topic 3: Performance measurement budgeting
 Accounting in Organisations and Society

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Accounting and its role in managerial activities
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Table of Contents
Learning Objectives ................................................................................................................. 1
Context of budgeting ............................................................................................................... 1
What is a budget? ................................................................................................................... 2
Why budget and to whom is it provided? ................................................................................ 3
What and how budget information should be provided? ......................................................... 4
Budget Administration ........................................................................................................... 10
Behavioural consequences of budgeting .............................................................................. 10

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Learning Objectives
• After completing this unit, you should be able to:
• Understand the context of budgeting.
• Explain what is a budget?
• Explain why to budget and to whom is it provided?
• Explain what and how budget information should be provided?
• Understand how to prepare different budgets.
• Describe an organisation’s budget administration process.
• Discuss behavioural consequences of budgeting.

Suggested Reading
Budgeting systems, in Langfield-Smith, Management Accounting 5nd ed.,
Thorne, Hilton, pp436 – 463.

Context of budgeting
In Module 1, we discussed how an organisation was a collection of people that used a range
of resources to create a product of value to customers. We also noted that the organisation
can influence, and/or is influenced by, the external environment and various stakeholders. In
this sense, an organisation is not comprised only of management but different influential
interest groups that can affect how it operates and performs its various activities. We also
should note that constant change in the external environment (e.g., globalisation, technology,
depletion of natural (scarce) resources) influences how an organisation performs and the
nature of accounts it provides, i.e., accounts also evolve over time in response to changes.
We identified that the role of organisational management was to:
• Plan - establish organisational goals/objectives - often multiple goals;
• Organise - allocate resources and responsibility to activities/functions of the organisation;
• Control - measure performance and provide feedback to management on how effective
and efficient the organisation had been in attaining its goals.
In this topic we examine Budgets and the process of budgeting as a part of organisational
management and its (changing) role in planning, organising and controlling.
Budgets reflect accounts of information that are produced by people, for people, which
influences decisions in a range of organisational activities including; production, research &

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development, marketing, and logistics. As such, budgets, as well as the process of

budgeting, are very much a social as well as a technical process.

What is a budget?
A budget is a detailed, quantitative plan (in financial and non-financial terms) of
management activities for a certain time period – normally a 12-month period. It is linked to
the organisation’s long-term strategic plans and goals. The strategic plan usually identifies
how value is to be created that gives the firm an advantage over competitors in the markets
it operates in. Long-term plans are usually finalised after considering the general (political,
economic, and social) and specific (competitors, customers, suppliers) environmental factors
that may influence the organisation’s operations. The budget essentially reflects the short-
term goals of the primary decision-makers in the organisation and is as a part of, and linked
to, the longer-term plan.

Reflection
Do you prepare your personal budget? Have you worked at a place where
you have been given a budget, for example, to sell a certain number pair
of shoes?

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Example
JB Hi-Fi recently entered into the home appliance market (refrigerators,
clothes irons, toasters etc). Prior to the launch of this project, JB Hi-Fi
opened a few concept shops, JB Hi-Fi Home, to understand customer
responses.
Can you list possible information that helped JB Hi-Fi’s decision-making
to enter the home appliance market? Why would a budget be helpful in
this process?

Why budget and to whom is it provided?

• Budgets are usually provided to those people within the organisation who have
responsibility (and are held to account) for the resources (e.g., labour, materials, cash)
used in undertaking particular activities. This might be, for example, the marketing
manager (for meeting sales goals), the purchasing manager (for purchasing the correct
amount and quality of supplies at certain prices) or the IT manager (for supplying
services and hardware to various activities). Each of these managers will have goals for
their activity area that link to the overall goal of the organisation.
• The budget is one of the most important means of communication within an organisation
and is essential for planning, organising and controlling activities. For example, to
measure performance of an activity, a specific goal/objective must be clearly established
in the first instance and resources organised and allocated to allow the goals in that
activity area to be achieved.
• As budgets for different activities are constructed, the different activity areas of the
organisation are required to communicate and plan the coordination of activities, e.g.,
marketing, purchasing and production need to align activities to ensure that a product of
value to the customer is provided on time and at the quality required. The finance
department must ensure it has sufficient cash to allow these activities to be undertaken.
You might notice here some similarities to the idea of a “value-chain” – linkages between
activities, which we discussed in the previous topic.
• The budget is also a way of indicating to people those factors that are considered
important. Changing goals will usually be reflected in budget changes.
• Budgets are also an important source of “feedback” which occurs when planned
performance is compared with actual performance. Differences are examined and
corrective action taken if needed; to ensure goals will be achieved. Budget comparisons
with actual performance, and the related feedback, also provide an account to those held
responsible for the activities on how they and their activity area have performed.

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Reflection
Consider the case of a student who is enrolled in a Bachelor of
Communication. After reading the course guide, you find that in order to
pass the first communication subject, you need to attend at least 80% of
tutorials, and achieve 50/100 in the final exam. In contrast, you only need
50/100 overall marks to pass your elective course, and there is no
requirement on attendance and no hurdle in the final exam.
When you are planning and controlling your study time, budgeting on your
study, are you going to take account of these factors? How will these
factors influence your behaviour?

What and how budget information should be

provided?
The type of information included in a budget can include both financial (e.g., sales revenue -
$) and non-financial (e.g., number of product returns) and is influenced by the particular
goals for that activity area (e.g., marketing or production targets). The technical process of
formulating budgets is described in detail in your suggested readings and a brief summary is
provided below:
The annual (often titled “master”) budget
The annual budget (or master budget) is a comprehensive set of budgets that cover all
aspects of a firm’s activities.
The annual budget consists of several interdependent budgets:
• Operating budgets include the sales budget and the various cost budgets;
• Financial budgets consist of the budgeted statement of financial performance, the
budgeted statement of financial position (we will learn in Module 3) and the cash budgets.
The operating budgets
The sales budget:
• Is a detailed summary of the estimated sales units and revenues from the organisation's
products for the budgeted year.
• Is based on the sales forecast, which involves estimating which products will be sold and
in what quantities. Sales forecasting is a critical step in the budgeting process and
market research is often used.
• Factors to consider when forecasting sales depend on the industry and nature of the
firms, but will include:
• Internal Factors: past sales levels, new products planned, intended pricing policy and
planned advertising and promotion.

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• External Factors: general economic trends, specific industry trends, political and legal
events, expected activities of competitors and customers. These were discussed in some
detail in Topic 1.

Guided Activity
William is an accountant for EFG Doors Manufacturing Company. The
expected sales for 2017 by each quarter year (Q) will be Q1 2000 units, Q2
2200 units, Q3 2400 units, Q4 2600 units. The selling price for each unit is
$500.
Prepare the sales budget based on sales forecast.
Solution

The cost budgets

Manufacturing firms
• A production budget includes cost budgets for direct materials, direct labour and
overheads. Direct materials are those physical resources used to manufacture a product,
e.g. wood used for creating a desk is considered a direct material. Direct Labour is the
cost of the human resources such as labourers who work to create the product, e.g., the
payment for the cabinet maker who constructs the desk but excludes costs of managers
and sales people. These costs that relate only to the manufacturing process are
described as direct. Overheads are the other resources used in the production process
such as cost of electricity or heating for the factory.
• Budgets for marketing, general and administrative expenses. General and administrative
expenses include resources used for activities other than the manufacturing process, e.g.
advertising costs, payments to managers and accountants, repayment of interest on
loans.
Retailers and wholesalers
• A purchasing budget will be used to determine the quantity and cost of goods purchased
for resale.

Guided Activity
This activity follows on from the previous activity. Inventory is a term used
to describe the total number or value of products the organisation
currently holds at a particular time. William would like to develop a
production budget. According to accounting records, the beginning
inventory is 200 doors and the inventory manager wants to increase

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inventory to 300 at the end of each quarter.

Prepare a production budget.
Solution

Guided Activity
Once production output has been estimated, William needs to determine
the cost of material purchases needed to manufacture the required
number of doors identified in the production budget (above). The
beginning material inventory is $30000 and the manager wants ending
materials inventory per quarter to be $40000 due to the sale increase.
The material cost is expected to be the same as last year which is $100
for each door.
Prepare a material budget.
Solution
EFG Doors Manufacturing Company Material Budget for the year ending
31 December 2017

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Guided Activity
Based on production requirements, labour hours for each door are 2
hours, and wages is $20 per hour.
Prepare a labour budget.
Solution

Guided Activity
In addition to labour and material costs, other costs for production and
support department also need to be included in the budget. Based on last
year’s information and reasonable forecasts, William developed the
following production overhead budget and selling and administrative
expenses budget.
Solution

The financial budgets

• The cash budget - Expected cash receipts and planned cash payments. The timing of
all cash movements is important to identify cash shortages and cash surpluses.
• Budgeted statement of financial performance (profit and loss)- Shows expected
revenues and planned expenses for the budget period.

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• Budgeted statement of financial position (balance sheet) - Expected assets and liabilities
at the end of budget period.

Guided Activity
You are an accountant working in Aza Pty Ltd. It is the beginning of the
year, and you are going to prepare a cash budget. The following depicts
the relevant information:
• The cash balance at the beginning of January 2017: $22,000
• Customers pay their bills one month after their purchase. The
sales for the last December is $98,000; and the expected sales
will be: January $139,000; February $140,000.
• A machine worth $34,000 will be sold in January for cash.
• Your company pays suppliers 50% of purchases in the same
month and the remaining 50% in the following month. The
purchase information for the last December is $68,000, and the
expected purchases will be January $76,000; February $30,000.
• Labour costs for the previous December were $55,000, the
expected salary in January is $50000, and February $58,000
(Wages are paid in the following month).
• Manufacturing overhead: January $30,000; February $28,000
(overhead will be paid when it occurs).
• Selling and administrative expenses: January $18,000; February
$17,000 (costs will be paid when they occur).
• A loan worth $10,000 will be due in January.
• Aza Pty Ltd expects to maintain a minimum $12,000 in cash on
hand at the end of each month. If the cash is not enough, they will
borrow from a local bank.

Required

Prepare a cash budget for the month of January and February.

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Solution

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Budget Administration
• In large organisations, formal processes are often used to collect data and prepare the
budget.
• Budget administration is often the responsibility of the senior accounting managers.
• A budget manual may be developed to communicate who is responsible for providing
various types of information, when the information is required and what form is it to take.
• A budget committee is often appointed to advise the accountants during the preparation
of the budget.

Behavioural consequences of budgeting

A budget affects virtually all people in an organisation;
• Those who prepare the budget,
• Those who use the budget for decision making, and
• Those whose performance is evaluated using the budget.
There are three general approaches to budgeting that might affect people’s behaviour:
• Participative budgeting: allows managers at all levels of the firm to develop their own
initial estimates for budgeted sales, costs, etc.
• Top-down budgeting: is where senior managers impose budget targets on less senior
managers.
• Bottom-up budgeting: is where employees at the lower managerial and operations
levels play an active part in setting their own budgets.
Participative budgeting generally encourages coordination and communication between
managers and a greater understanding and appreciation of the wider organisation. It may
also lead to more accurate budget estimates, as those close to the operations have the best
knowledge of the likely sales or costs in their area and this approach provides a greater level
of motivation for people to work toward budget goals.
Budget acceptance is generally more likely when:
• Targets are developed with employee participation
• Targets are considered achievable
• There is frequent feedback on performance
• Employees are held responsible for activities that are within their control
• Achievement of targets is accompanied by rewards that are valued
• Budgets must be set at a level that provides challenges and stretch, but not too difficult.

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Additional Guided Activity for the Service Entity Budgeting

Joe is the owner of a fitness club – ABC fitness. In the first year of
operation, the business attracted a large number of clients. Before the
start of next year, Joe came to his accountant and asked for a budget for
the next 12 months.
The following is an overview of the budget preparation for the period from
January to December 2017, undertaken by the accountant.
The start point is to estimate a sales budget which requires market
analysis. Based on marketing analysis, the accountant expected that the
number of memberships sold next year is 90 for Gold, 170 for Silver and
380 for bronze, and the membership fee is $5000, $2000, and $1000
respectively. Gold members have access 24 hours a day, seven days per
week; Silver members have access from 6 am to 10pm seven days per
week while Bronze members have access on weekends between 6am
to10 pm.
ABC Fitness hired 14 employees in total, the following table lists the role
of each employee and their annual salary package.

ABC Fitness expects the following operating expenses based on its

previous years results. Joe expects there will be no changes in the
operating expenses in the next year.

Required
a) Prepare a sales budget to determine the estimate of total revenue.
b) Prepare a labour budget for the year ending 31 Dec 2017.
c) Prepare a Statement of Profit or Loss Budget for the year ending 31
December 2017.

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Solution
a) Prepare a sales budget to determine the estimate of total revenue.

b) Prepare a labour budget for the year ending 31 Dec 2017.

c) Prepare a Statement of Profit or Loss Budget for the year ending 31

December 2017.

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Reflection
Budgeting case study – behavioural and social and environmental
considerations
Snacky McSnack Pty Ltd is a medium-sized and very successful
Australian manufacturer of “healthy snack foods”. The organisation is
planning for the next year and formulating budgets for its many
departments including marketing, purchasing and production. The
purchasing manager has found a new source of palm oil, an ingredient
that is used in making most of its products. Palm oil is currently sourced
from an Australian organisation, Palm Plantations of Australia Pty Ltd
(PPA) (http://www.palmplantations.com.au/) a leader in the supply of
sustainable palm oil. The proposed new supplier of palm oil – Cheapo de
Palma - is located in South-east Asia and can supply palm oil at a price
50% less than the current Australian supplier.
Budgeted financial profit can be substantially increased if PPA changes to
the new supplier of palm oil. The budgeted purchasing and production
costs can be substantially reduced although there will be increased freight
costs as the oil will be transported by road and sea. The CEO of Snacky
McSnack, who receives a monetary bonus based on the company’s
profits, has decided to change to the new supplier; however, the CEO has
received strong objections from the marketing manager who thinks that
sales of products might decline as the palm oil is not “sustainable” palm
oil. The marketing manager receives a monetary bonus that is based on
sales revenue.

Required:
a) Discuss reasons why the marketing manager might think sales of
products will decline
b) Discuss what social and/or environmental costs/benefits might be
experienced if Snacky McSnack changes suppliers
c) Discuss how, or whether, these social and/or environmental
costs/benefits might be accounted for in the budgets
d) Discuss whether you consider the bonuses that are received by
managers at Snack McSnack are beneficial for the organisation
e) What do you think the CEO will do?

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Case Study – DC Surf Co.

Download Video: https://smoovivideov1.s3.amazonaws.com/11fce144-8af0-
e234_7452.mp4

Background:
De and Claire studied a business course together 5 year ago. De majored
in Marketing and Claire majored in International Business. They met
through the University Surfing Club.
De works full-time as a marketing Assistant for a major retailer. On the
weekends he shapes surfboards in his shed. It started out as a hobby but
he has now started selling his boards in a few local surf shops. Claire
works part-time for a graphic design firm. She also designs her own t-
shirts and sells them online. She currently ships her t-shirts to 7 different
countries throughout South East Asia as well as the US.
De and Claire surf together a couple of times a month and often talk about
starting a business together. Finally, they have decided to take the plunge
and have set up ‘DC Surf Co’ with the vision of supplying high quality
surfing equipment and apparel. They have decided to start small but have
plans to grow quickly. For now, they are operating from a small home
office in De’s lounge room.
De and Claire decided to set up their business as a partnership. They
employed De’s neighbour Johnny on a part-time basis to assist with
setting up the website and other administrative tasks so that De and Claire
can focus on growing the business. De already had a relationship with a
few of the local surf shops and they have agreed to stock the full range of
DC Surf Co boards and apparel. They have also started selling their
goods online through their website. They have made a few bulk purchases
of materials (fibreglass, cotton, fabric) and are storing these in De’s lounge
room. They realise that they are quickly running out of space and expect
to either rent or purchase commercial premises within the next 6 months.
De and Claire considered restructuring the business from a partnership to
a company. They initially set up the business as a partnership because it
seemed to be the easiest and least expensive option but they then
wondered if perhaps they made the decision in haste and should have
researched business structures more thoroughly before making their
choice. After further consideration, they restructured the partnership into a
company.
A large surfboard manufacturer has recently received negative media
attention for importing their surfboards into Australia from China where the
workers are subject to unsafe working and poor wage conditions. DC Surf
Co have noticed that a lot of potential customers are now enquiring as to
how and where DC Surf Co makes their boards. De is still manufacturing
his boards locally and has now employed one experienced staff member
and one trainee to assist him. Prior to the recent media attention, no-one

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really asked about the origins of the boards and De has never made an
effort to voluntarily provide this information.
De decided to label his locally made boards with a sticker which says
“designed and made locally in Australia”. Since promoting his boards as
locally made, De has noticed a significant increase in sales but is finding
that most of this extra money is being used to purchase materials and pay
staff wages. De isn’t sure how well the business is performing and how he
should best go about improving the performance of the business. He
came across this article about how to make a living as a surfboard maker
and has decided that he and Claire should develop a business plan for
their business. De also thinks that they should hire an accountant to assist
them in their business but Claire isn’t convinced that this is necessary and
is worried about the extra cost. They decide on a compromise which is to
advertise a position for a part-time accountant to work in the business 2-3
days per week. Congratulations, you got the job!
With your help De and Claire have prepared and implemented a business
plan which they hope will increase sales, reduce costs and help their
business to perform better overall. Their vision is to become an emerging
leader in the surfing industry with a reputation for high quality products
and great service. It has now been six months since the plan was put into
place and from De and Claire’s perspective, the business seems to be
going well.
DC Surf Co’s surfboards are currently stocked by 22 different surf shops.
In order to keep up with the demand, De and Claire have hired an
additional two trainees and one experienced staff member to assist with
the surfboard manufacturing. A great deal of time has gone into training
the new trainees and while they were learning they made some mistakes
in the manufacturing process that were not detected until the boards were
purchased and used by customers. In total, out of 192 board produced, 16
boards were returned to DC Surf Co. The business replaced 12 of these
boards and issued refunds for the remaining 4 boards. DC Surf Co.
retained the faulty boards so that the current and any future trainees could
use these boards to practice their board shaping skills.
The apparel line is also growing. The business produces t-shirt which are
also stocked by the 22 surf-shops and are sold online both in Australia
and overseas. A celebrity was recently photographed in one of the t-shirts
and since then the t-shirts sales have tripled and the business has
temporarily sold out of some of the most popular styles and has been
unable to fulfil some customer orders. Whilst customer reviews on
Facebook initially spiked at 4.8 stars, since running out of stock, some
customers have become frustrated and their current rating has decreased
to 4.1.
In order to leverage from the popularity of their t-shirts, De is keen to add
board shorts to their apparel line. Claire is not convinced that this is a
good idea and is concerned that board shorts are a very seasonal item
and that people do not buy shorts all year round. T-shirts on the other
hand are purchased by customers even during the winter time to wear
underneath warmer clothing. Before taking a risk on the new board short

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line, De and Claire want to have a clear understanding of how the

business is currently performing.

Additional Information
With your help De and Claire make the decision to proceed with the board
short line and it is a huge success. It is now 3 years on and the business
now stocks a full range of both men’s and women’s apparel including
hoodies, tracksuit pants and hats. They have also decided to expand their
line into beach towels which they will manufacture themselves. They have
invited you to attend a meeting to discuss their expectations in terms of
the beach towel range. You make a list of the key points discussed at the
meeting as follows:

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Activity 1
From the information obtained during the meeting prepare the following
operating budgets (with a quarterly breakdown) for the new beach towel
line for the year ending 30 June 2017:
1. Sales Budget
2. Production Budget
3. Material Budget
4. Labour Budget
5. Overhead Budget

Activity 2
De and Claire have also asked you to prepare a monthly cash budget, a
budgeted statement of financial performance and a budgeted statement
of financial position for the year ended 30 June 2017 for the business
overall. You have decided to start with the cash budget and have
arranged a meeting with De and Claire so you can discuss any additional
information you may need in order to complete this task.
List 3 pieces of information that you will require before you are able to
complete the cash budget.
Provide a brief explanation as to why this information is required.

Activity 3
Part of the business plan is to pay a bonus to all staff involved in
manufacturing based on the number of towels produced each month. A
further bonus will be paid if the labour and/or material cost per beach
towel is reduced. To reduce costs (and potentially get a bonus) the new
employee in production has sourced lower cost, slightly inferior, materials
from overseas which will save at least 20% on the material cost.

a) De and Claire have asked you if the performance measure and

reward for manufacturing staff increasing the number of towels
produced may affect their behaviour in any way. Please discuss
any benefits or disadvantages that you consider may arise.

b) Discuss the implications for the business of sourcing low cost,

slightly inferior, materials from overseas.

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