Question

Speedy Curry is a manufacturer of curry ready meals, and it has used a traditional incremental budgeting system for a number of years. In the past the system has seemed to work well, the budgets prepared by the accounting team have been well received by managers and targets set have been generally achieved.

In the last few years however, it has become apparent that the budgeting system has not been running as smoothly. The production manager has been called to see the Divisional Managing Director to explain why the production budget has not been met. The sales manager has also been called on to explain why the number of customer complaints has risen in relation to quality and why delivery times and sales targets have not been achieved.

On investigation you find the following information:

1. The divisional accounting team have been preparing production and sales budgets without any participation from the production manager or sales manager. This budgeted information has been used to set targets for these two managers.

2. In an attempt to keep costs down the production manager altered the raw material mix to use more of the cheaper sauce and less of the expensive chicken in the best-selling curry.

3. The sales manager took on an extra order for the best-selling chicken curry of 2,000 units even though the factory was at 95% capacity [full capacity would be 100,000 units].

4. There is a big swing in the ready meal market towards customers preferring vegan curry rather than chicken.

A) Critically discuss the role of participation in the budgeting process. Comment on why the information found above may lead to ineffective budgeting and inability to meet targets

B) Consider how variances such as Mix and Yield and Planning and Operational variances could be used by the division to aid in the evaluation of the managers performance. Use numerical illustrations to support your answer.

Answer 1

A. Critically discuss the role of participation in the budgeting process. Comment on why the information found above may lead to ineffective budgeting and inability to meet targets

CONCEPT

The term budget has negative connotations for many employees. Often in the past, management has imposed a budget from the top without considering the opinions and feelings of the personnel affected. Such a dictatorial process may result in resistance to the budget. A number of reasons may underlie such resistance, including lack of understanding of the process, concern for status, and an expectation of increased pressure to perform. Employees may believe that the performance evaluation method is unfair or that the goals are unrealistic and unattainable. They may lack confidence in the way accounting figures are generated or may prefer a less formal communication and evaluation system. Often these fears are completely unfounded, but if employees believe these problems exist, it is difficult to accomplish the objectives of budgeting.

Problems encountered with such imposed budgets have led accountants and management to adopt participatory budgeting. Participatory budgeting means that all levels of management responsible for actual performance actively participate in setting operating goals for the coming period. Managers and other employees are more likely to understand, accept, and pursue goals when they are involved in formulating them.

Within a participatory budgeting process, accountants should be compilers or coordinators of the budget, not preparers. They should be on hand during the preparation process to present and explain significant financial data. Accountants must identify the relevant cost data that enables management’s objectives to be quantified in dollars. Accountants are responsible for designing meaningful budget reports. Also, accountants must continually strive to make the accounting system more responsive to managerial needs. That responsiveness, in turn, increases confidence in the accounting system.

Although many companies have used participatory budgeting successfully, it does not always work. Studies have shown that in many organizations, participation in the budget formulation failed to make employees more motivated to achieve budgeted goals. Whether or not participation works depends on management’s leadership style, the attitudes of employees, and the organization’s size and structure. Participation is not the answer to all the problems of budget preparation. However, it is one way to achieve better results in organizations that are receptive to the philosophy of participation.

ADVANTAGES OF PARTICIPATIVE BUDGETING

The following are some of the benefits of implementing a participative budgeting approach in an organization:

1. Transfer of information upwards: One of the advantages of participative budgeting is the sharing of information from departmental-level managers to top management. It means that subordinate managers are given the opportunity to present their views on certain organizational issues.

The managers also get a chance to discuss the difficulties that they encounter in budget preparation and brainstorm ways of solving the problems. Both the top managers and the subordinates are also able to share their points of view on certain issues of interest.

2. Employee motivation: When employees are involved in the budget preparation process, they get to own a part of the budgeting process. It gives them a sense of ownership when their suggestions are taken into account by senior management. They also feel appreciated by management when they are given an opportunity to sit down with the top managers and share their views on certain points of interest. Employee involvement in the process improves their morale, providing them with a greater urge to work harder towards the attainment of the goals that they helped set.

3. Goal congruence: Goal congruence refers to the agreement between the employee’s goals and the overall company goals. In order for the company to create a budget that is achievable, both the management and the staff must set goals that move in the same direction.

For example, if the goal of the company is to double the production capacity in the next year, it should be shared with the employees since they are the people tasked with implementing the proposal. If there is no agreement between the company’s goals and the subordinate managers’ goals, it will be impossible to attain the set targets.

DISADVANTAGES OF PARTICIPATIVE BUDGETING

1. Time-consuming :The most common limitation of a participative budget is that it is time-consuming compared to an imposed budget. Since the budget preparation starts from the department level to the top, too much participation may occur that may derail the process. Involving all employees in each department will mean that the negotiations may take too long before the staff reaches an agreement. If there is no agreement, the management will need to make the final decision, which means that the staff will need to accept an imposed decision.

2. Budgetary slack :The other limitation is budgetary slack. The employees may overestimate the costs and/or underestimate the revenue projections as a way of manipulating the budget to their advantage. It means that the subordinate managers will set targets that they are sure to achieve and even exceed in the next financial year. This mostly happens when the manager’s performance is measured on the basis of the attainment of the budget. By making the budget easy to achieve, the managers will be seen as exceeding their targets.

FOLLOWING ARE THE CONSEQUENCES OF IMPOSED BUDGET ON SPEEDY CURRIES AND HOW IT COULD BE BETTER IF PARTICIPATORY BUDGET WAS DONE.

Ø The imposed budget has leaded the production manager to manufacture the best-selling curry in a given cost otherwise the standard costing would show a adverse variance in production cost. Since the Quality cannot be measured in Standard Costing methods he has to use an inferior quality raw material to keep the costs low. However it has also affected the quality of the product adversely. Had is inputs been taken in the Budgetary process he could have told the divisional accounting team that the given cost would degrade the quality of the product.

Ø Since the Production manager & Sales managers did not interact with each other The Sales manager was unaware of the Factory Capacity used and took and extra order to give out better performance or Favorable Variance. Also the Production manager doesn’t have access to the information of market’s taste and Preference. This has leaded to production of the past “BEST SELLING CURRY” which is not the markets favorite now.

Ø A business is collective effort. If participatory budgets are prepared one department can get inputs from other department and that can change the level of cooperation amongst the department and performance will be effective.

Ø There are Qualitative aspects to budget preparation and only specialization can let the recognition of those aspect happen. The divisional Accounting Team is not specialized in Sales or Production process. So the Qualitative aspects are ignored in preparation of budget leading to an irrelevant performance.

B. Consider how variances such as Mix and Yield and Planning and Operational variances could be used by the division to aid in the evaluation of the managers performance. Use numerical illustrations to support your answer.   

MIX & YIELD VARIANCE

A mix variance is used to monitor the cost of material. For instance, if more of an expensive material has been used and less of a cheap material, then the overall cost will be higher - and the variance adverse.

A yield variance measures the efficiency of turning the inputs into outputs. If the yield variance is adverse, it suggests that actual output is lower than the expected output. This could be due to labour inefficiencies, higher waste, inferior materials, or using a cheaper mix with a lower yield.

ILLUSTRATION.

The Organic Bread Company (OBC) makes a range of breads for sale direct to the public. The production process begins with workers weighing out ingredients on electronic scales and then placing them in a machine for mixing. A worker then manually removes the mix from the machine and shapes it into loaves by hand, after which the bread is then placed into the oven for baking.

All baked loaves are then inspected by OBC’s quality inspector before they are packaged up and made ready for sale.

Any loaves which fail the inspection are donated to a local food bank.

The standard cost card for OBC’s ‘Mixed Bloomer’, one of its most popular loaves, is as follows:

		$
White flour	450 grams at $1·80 per kg	0·81
Wholegrain flour	150 grams at $2·20 per kg	0·33
Yeast	10 grams at $20 per kg	0·20
Total	610 grams	1·34

Budgeted production of Mixed Bloomers was 1,000 units for the quarter, although actual production was only 950 units. The total actual quantities used and their actual costs were:

	Kg	$ per kg
White flour	408·5	1·90
Wholegrain flour	152·0	2·10
Yeast	10·0	20·00
Total	570·5

Required:
(a) Calculate the total material mix variance and the total material yield variance for OBC for the last quarter.

SOLUTION

Variance calculations

Mix variance
Per question, total g of materials per standard batch = 610 g.
Therefore standard quantity to produce 950 units = 950 x 610 g = 579·5 kg
Per question, actual total kg of materials used to produce 950 units = 570·5 kg

Material		Actual quantity in actual mix	Actual quantity in standard mix	Variance	Standard cost per kg	Variance
		Kg	kg	kg	$	$
White flour	570·5 x 450/610 =	420·86	408·5	12·36	1·80	22·25
Wholegrain flour	570·5 x 150/610 =	140·29	152	(11·71)	2·20	(25·76)
Yeast	570·5 x 10/610 =	9·35	10	(0·65)	20	(13)
		570·5	570·5	20·5		(16·51) A

Yield variance

Material		Actual quantity in actual mix	Actual quantity in standard mix	Variance	Standard cost per kg	Variance
		Kg	kg	kg	$	$
White flour	450/610 x 579·5 =	427·5	420·86	6·64	1·80	11·95
Wholegrain flour	150/610 x 579·5 =	142·5	140·29	2·21	2·20	4·86
Yeast	10/610 x 579·5 =	9·5	9·35	0·15	20	3
		579·5	570·5			19·81F

Alternative yield calculation

570·5 kg should yield (÷ 0·61 kg)	= 935·25 loaves
570·5 kg did yield	= 950 loaves
Difference	14·75 F
Valued at standard material cost	= 14·75F x $1·34 = $19·77F

PLANNING & OPERATIONAL VARIANCE

Planning and operational variances for sales

The sales volume variance can be sub-divided into a planning and operational variance:

Planning and operating variances for costs

When applying planning and operating principles to cost variances (material and labour), care must be taken over flexing the budgets. One accepted approach is to flex both the original and revised budgets to actual production levels:

Illustration 1- Revising the budget

Rhodes Co manufactures Stops which it is estimated require 2 kg of material XYZ at $10/kg In week 21 only 250 Stops were produced although budgeted production was 300. 450 kg of XYZ were purchased and used in the week at a total cost of $5,100. Later it was found that the standard had failed to allow for a 10% price increase throughout the material supplier's industry. Rhodes Ltd carries no stocks.

Planning and operational analysis

The first step in the analysis is to calculate:

(1) Actual Results

(2) Revised flexed budget (ex-post).

(3) Original flexed budget (ex-ante).

Illustration 2 - Revising the budget

A transport business makes a particular journey regularly, and has established that the standard fuel cost for each journey is 20 litres of fuel at $2 per litre. New legislation has forced a change in the vehicle used for the journey and an unexpected rise in fuel costs. It is decided retrospectively that the standard cost per journey should have been 18 litres at $2.50 per litre.

Required:

Calculate the original and revised flexed budgets if the journey is made 120 times in the period.

Solution

When should a budget be revised?

There must be a good reason for deciding that the original standard cost is unrealistic. Deciding in retrospect that expected costs should be different from the standard should not be an arbitrary decision,aimed perhaps at shifting the blame for bad results due to poor operational management or poor cost estimation.

A good reason for a change in the standard might be:

• a change in one of the main materials used to make a product or provide a service
• an unexpected increase in the price of materials due to a rapid increase in world market prices (e.g. the price of oil or other commodities)
• a change in working methods and procedures that alters the expected direct labour time for a product or service
• an unexpected change in the rate of pay to the workforce.

These types of situations do not occur frequently. The need to report planning and operational variances should therefore be an occasional, rather than a regular, event.

If the budget is revised on a regular basis, the reasons for this should be investigated. It may be due to management attempting to shift the blame for poor results or due to a poor planning process.

Further thoughts on calculating planning and operating variances in accountancy exams

The basic idea given above is that

Key question: what is the revised budget volume?

There are three different ways of approaching planning and operating variances in accountancy exams.

Approach 1:

(Note: In many respects this is the best approach but over-complex for most Paper questions and needs the most information. It was required for the old syllabus ACCA paper 9 Paper)

If a revised volume is given (or can be easily calculated) then the best approach is to do two completely separate sets of variances.

This will result in the situation where the total traditional variance = planning + operating variances in total only but not line by line (e.g. materials price planning variance + materials price operating variance will not give the traditional materials price variance)

Approach 2:

(Note: This is the approach currently used for ICAEW exams and used to be the approach for ACCA F5 until the current examiner took charge. Note: you will still be given credit for this approach in the ACCA F5 Paper.)

If no obvious revised volume is given (or can be calculated) then set revised budget volume = actual volume. This means that all cost variances are based on the actual output.

In this approach:

• No operating sales volume variance – its all planning
• Sales volume variance is thus effectively calculated on Original Standard Margin
• Planning cost variances will be based on actual output volumes
• Traditional variances = operating + planning variances on a line by line basis now rather than just in total
• Note that if the original budgeted volume is not given in the questions, then this approach must be used.

Approach 3:

(Note: this approach seems to make more sense when only minor changes are made to the original budget - usually just a couple of prices. It is also the approach currently used for CIMA P1 and ACCA F5 exams.)

if no obvious revised volume is given (or can be calculated) then set revised budget volume = original budget volume.

In this approach:

• There is no planning sales volume variance – its all operating
• Sales volume variance is thus effectively calculated on Revised Standard Margin
• Planning cost variances will be based on original budgeted volumes
• Total traditional variance = planning + operating in total only but not line by line