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Budgetary Control
Static Budgets
Flexible Budgets
Responsibility Accounting
Responsibility Reports/Cost
Responsibility Reports -Profit
Investment Centers
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Budgeting and Budgetary Control
ELS
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Budgetary Control
Static Budgets
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Responsibility Reports -Profit
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Budgetary Control and Responsibility Accounting
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Management Functions
• Planning
• Directing and Motivating
• Controlling
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Budgetary Control
• One of the three main functions of management is to control.
• Budgets are useful in controlling operations.
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Budgetary Control
Static Budgets
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Budgetary Control
The use of budgets to control operations. Compare actual results with planned objectives.
BUD
GETFIN
ANCIAL
STATEMENTS
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Budgetary Control
Static Budgets
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Budgetary ControlIllustration 7-1
Budgetary Control Reporting System
Illustration 7-2
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Budgetary Control
Static Budgets
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Static Budget
A projection of budget data at one level of activity.
Budgeted Production in units (steel ingots) 10,000Budgeted Costs Indirect materials $ 250,000 Indirect labor 260,000 Utilities 190,000 Depreciation 280,000 Property taxes 70,000 Supervision 50,000
$1,100,000
Budgeted Production in units (steel ingots) 10,000Budgeted Costs Indirect materials $ 250,000 Indirect labor 260,000 Utilities 190,000 Depreciation 280,000 Property taxes 70,000 Supervision 50,000
$1,100,000
Barton Steel (Forging Department)Manufacturing Overhead Budget (Static) For the Year Ended December 31, 2002
Illustration 7-6
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Budgetary Control
Static Budgets
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Static Budget
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Budgetary Control
Static Budgets
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Flexible Budget
A projection of budget data for various levels of activity.
Flexible BudgetIllustration 7-13
Fox Manufacturing Company (Finishing Department)Flexible Monthly Manufacturing Overhead Budget
For the Month Ended January 31, 2002
Activity level Direct labor hours 8,000 9,000 10,000 11,000 12,000Variable costs Indirect materials ($1.50) $12,000 $13,500 $15,000 $16,500 $18,000 Indirect labor ($2.00) 16,000 18,000 20,000 22,000 24,000 Utilities ($.50) 4,000 4,500 5,000 5,500 6,000 Total variable 32,000 36,000 40,000 44,000 48,000Fixed costs Depreciation 15,000 15,000 15,000 15,000 15,000 Supervision 10,000 10,000 10,000 10,000 10,000 Property taxes 5,000 5,000 5,000 5,000 5,000 Total fixed 30,000 30,000 30,000 30,000 30,000Total costs $62,000 $66,000 $70,000 $74,000 $78,000
Activity level Direct labor hours 8,000 9,000 10,000 11,000 12,000Variable costs Indirect materials ($1.50) $12,000 $13,500 $15,000 $16,500 $18,000 Indirect labor ($2.00) 16,000 18,000 20,000 22,000 24,000 Utilities ($.50) 4,000 4,500 5,000 5,500 6,000 Total variable 32,000 36,000 40,000 44,000 48,000Fixed costs Depreciation 15,000 15,000 15,000 15,000 15,000 Supervision 10,000 10,000 10,000 10,000 10,000 Property taxes 5,000 5,000 5,000 5,000 5,000 Total fixed 30,000 30,000 30,000 30,000 30,000Total costs $62,000 $66,000 $70,000 $74,000 $78,000
Flexible Budget at 10,000 and 12,000 LevelsIllustration 7-15
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Management by Exception
The review of budget reports by management focused entirely or primarily on differences between actual results and planned objectives.
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Responsibility Reporting System The preparation of reports
for each level of responsibility in the company’s organization chart.
Illustration 7-17
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Controllable Costs
Costs that a manager has the authority to incur within a given period of time.
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Responsibility for Controlling CostsIllustration 7-17
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Decentralization
Control of operations is delegated to many managers throughout the organization.
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Segment
An area of responsibility in decentralized operations.
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Responsibility Accounting
A part of management accounting that involves accumulating and reporting revenues and costs on the basis of the manager who has the authority to make the day-to-day decisions about the items.
Illustration 7-20
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Direct Fixed Costs
Costs that relate specifically to a responsibility center and are incurred for the sole benefit of the center.
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Indirect Fixed Costs
Costs that are incurred for the benefit of more than one profit center.
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Cost Center
A responsibility center that incurs costs but does not directly generate revenues.
Warranty Dept
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Profit Center
A responsibility center that incurs costs but also generates revenue.
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Investment Center
A responsibility center that incurs costs, generates revenues, and has control over the investment funds available for use.
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Illustration 7-18
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Responsibility ReportContribution margin less controllable
fixed costs=Controllable Margin.
Illustration 7-22
Difference Favorable F
Budget Actual Unfavorable USales $1,200,000 $1,150,000 $50,000 UVariable Costs Cost of goods sold 500,000 490,000 10,000 F Selling & administrative 160,000 156,000 4,000 F Total 660,000 646,000 14,000 FContribution margin 540,000 504,000 36,000 UControllable fixed costs Cost of goods sold 100,000 100,000 -0- Selling & administrative 80,000 80,000 -0- Total 180,000 180,000 -0- Controllable margin $ 360,000 $ 324,000 $36,000 U
Difference Favorable F
Budget Actual Unfavorable USales $1,200,000 $1,150,000 $50,000 UVariable Costs Cost of goods sold 500,000 490,000 10,000 F Selling & administrative 160,000 156,000 4,000 F Total 660,000 646,000 14,000 FContribution margin 540,000 504,000 36,000 UControllable fixed costs Cost of goods sold 100,000 100,000 -0- Selling & administrative 80,000 80,000 -0- Total 180,000 180,000 -0- Controllable margin $ 360,000 $ 324,000 $36,000 U
Mantel Manufacturing Company (Marine Division)Responsibility Report
For the Year Ended December 31, 2002
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Residual Income
The income that remains after subtracting from the controllable margin the minimum rate of return on a company’s operating assets.
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Return on Investment (ROI)A measure of management’s
effectiveness in utilizing assets at its disposal in an investment center.
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Principles of Performance Evaluation• Managers of responsibility centers should have direct
input into the process of establishing budget goals of their area of responsibility.
• The evaluation of performance should be based entirely on matters that are controllable by the manager being evaluated.
• Top management should support the evaluation process.• The evaluation process must allow managers to respond
to their evaluations.• The evaluation should identify both good and poor
performance.
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• Capital Budgeting Analysis
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• Traditional Capital Budgeting Techniques
– Payback Period Approach– Discounted Payback Period Approach– Discounted Cash Flow Techniques
• Net Present Value• Internal Rate of Return• Profitability Index• Net Present Value versus Internal Rate of Return
• Outline
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• Capital budgeting addresses the issue of strategic long-term investment decisions.
• Capital budgeting can be defined as the process of analyzing, evaluating, and deciding whether resources should be allocated to a project or not.
• Process of capital budgeting ensure optimal allocation of resources and helps management work towards the goal of shareholder wealth maximization.
• Meaning of Capital Budgeting
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• Considered to be the most important decision that a corporate treasurer has to make.
• So much is the significance of capital budgeting that many business schools offer a separate course on capital budgeting
• Significance of Capital Budgeting
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• Involve massive investment of resources
• Are not easily reversible• Have long-term implications for
the firm• Involve uncertainty and risk for
the firm
• Why Capital Budgeting is so Important?
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• Due to the above factors, capital budgeting decisions become critical and must be evaluated very carefully.
• Any firm that does not follow the capital budgeting process will not be maximizing shareholder wealth and
• Management will not be acting in the best interests of shareholders.
• RJR Nabisco’s smokeless cigarette project example– Project initiated in 1989– More than $300 million was invested– Had 2 flaws- required special lighter & was tasteless
for smoker– Within 2 years the project failed to deliver
Why Capital Budgeting is so Important?
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• Similarly:• Euro-Disney,
– Failed miserably because of following factors :– Cultural gap’s – French felt that their children might loose
french culture as it had more of English culture– Europeans love travelling and not interested in 1 day
vaccation– All Investments were Bad (Lost everything) . 1st year $900m
loss. • Concorde Plane,
– Too noisy– Too expensive– Plane crash in 2000- killed 113 passengers
• Saturn of GM – Best selling model to kill competition from Japan cars– For 5 years GM did not make any other model– After 5 years brought various models killing the Saturn
model
All faced problems due to bad capital budgeting, while Intel became global leader due to sound capital budgeting decisions in 1990s.
Why Capital Budgeting is so Important?
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• Payback Period Approach
• Discounted Payback Period Approach
• Net Present Value Approach
• Internal Rate of Return
• Profitability Index
• Techniques of Capital Budgeting Analysis
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• A technique that helps us in selecting projects that are consistent with the principle of shareholder wealth maximization.
• A technique is considered consistent with wealth maximization if – It is based on cash flows
– Considers all the cash flows
– Considers time value of money
– Is unbiased in selecting projects
• Which Technique should we follow?
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• The amount of time needed to recover the initial investment
• The number of years it takes including a fraction of the year to recover initial investment is called payback period
• To compute payback period, keep adding the cash flows till the sum equals initial investment
• Simplicity is the main benefit, but suffers from drawbacks
• Technique is not consistent with wealth maximization—Why?
• Payback Period Approach
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• Similar to payback period approach with one difference that it considers time value of money
• The amount of time needed to recover initial investment given the present value of cash inflows
• Keep adding the discounted cash flows till the sum equals initial investment
• All other drawbacks of the payback period remains in this approach
• Not consistent with wealth maximization
• Discounted Payback Period
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• Based on the Rupees amount of cash flows• The Rupee amount of value added by a
project• NPV equals the present value of cash
inflows minus initial investment• Technique is consistent with the principle
of wealth maximization—Why?• Accept a project if NPV ≥ 0
• Net Present Value Approach
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• The rate at which the net present value of cash flows of a project is zero, I.e., the rate at which the present value of cash inflows equals initial investment
• Project’s promised rate of return given initial investment and cash flows
• Consistent with wealth maximization• Accept a project if IRR ≥ Cost of
Capital
• Internal Rate of Return
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• Usually, NPV and IRR are consistent with each other. If IRR says accept the project, NPV will also say accept the project
• IRR can be in conflict with NPV if – Investing or Financing Decisions– Projects are mutually exclusive
• Projects differ in scale of investment• Cash flow patterns of projects is different
– If cash flows alternate in sign—problem of multiple IRR
• If IRR and NPV conflict, use NPV approach
• NPV versus IRR
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• A part of discounted cash flow family• PI = PV of Cash Inflows/initial investment• Accept a project if PI ≥ 1.0, which means
positive NPV• Usually, PI consistent with NPV• PI may be in conflict with NPV if
– Projects are mutually exclusive• Scale of projects differ• Pattern of cash flows of projects is different
• When in conflict with NPV, use NPV
• Profitability Index (PI)
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• Replacement Chain Analysis
• Equivalent Annual Cost Method
• If two machines are unequal in life, we need to make adjustment before computing NPV.
• Evaluating Projects with Unequal Lives
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• Although our decision should be based on NPV, but each technique contributes in its own way.
• Payback period is a rough measure of riskiness. The longer the payback period, more risky a project is
• IRR is a measure of safety margin in a project. Higher IRR means more safety margin in the project’s estimated cash flows
• PI is a measure of cost-benefit analysis. How much NPV for every dollar of initial investment
• Which technique is superior?