Concepts and Techniques of

Responsibility Budgeting,
Developing Responsibility
Budgets and Budgeting With MBO
System

Team Members
Nishit Shetty
Kamlesh Damania
Chetan Bhagwat
Melwyn Gonzalves
Viral Desai
Bhavesh Joshi
Amol Naik

Roll No
279
212
205
225
215
231
246

Sr.n
o

Particulars

Concept and Technique of Responsibility Budgeting

Pg
#

Roll
No

3-5

205

6-7

231

8-10

215

11-16

279

Governance arrangement, Administrative process,

Contractual Relationship
2

Types of Responsibility Centres

Strategic management perspective on Responsibility
Budgeting and accounting

Diagnostic versus Interactive Control

The other Axis of Responsibility Centre Design

Transfer pricing & Developing responsibility budgets

Advantages & disadvantages

Operating budget types: Sales Budget, Production

budget

17-19

246

Factory overhead budget, Alternative calculation for

Budgeted factory
overhead cost, Ending inventory budget, Cost of
goods sold budget,
Selling & Administrative expense budget, Budgeted
income statement

20-25

225

Financial Budget

26-32

212

Budgeting with MBO system

Page 2

Concept and Technique of Responsibility

Budgeting
The gist of 20th century thinking management control is expressed by the
mantra: let the managers manage; make the managers manage.
Responsibility budgeting is to empower managers to manage and, at the
same time, motivate them to use their collective intelligence to create value
through exchange in product and financial markets and by establishing and
sustaining mutually beneficial relationships with customers, suppliers, and
especially other members of their organizations.
In this article explain the nature of responsibility budgeting, its intellectual
justification, its antecedents, and its present and future use. This is not a
straightforward task. We cannot simply explain how responsibility budgeting
is used and how it works. Responsibility budgeting makes sense only as a
part of a framework of structural, procedural, and monitoring/reporting
relationships. We must, therefore, also explain the framework that gives it
utility and power. At the same time, responsibilities budgeting and
accounting, or their functional equivalents, make an essential contribution to
the efficacy of this broader framework of relationships. One cannot arbitrarily
mix and match administrative relationships and expect that the outcome will
be productive. The efficacy of administrative relationships depends upon
their congruity with each other as well as with the purposes and products of
the entity in question and the productive and information processing
technologies available to it.
Responsibility budgeting is now the most common remote control system
used by large-scale organizations in the private sector. Within the accounting
literature, agency theorists (e.g., Zimmerman 1995) tend to interpret
responsibility budgeting as a practice for structuring the contractual
relationship between providers of economic resources (principals) and those
who apply those resources in economic activity (agents). The broad outline
of this relationship is one where substantial decisional authority is
decentralized to agents, within the context of well-specified rules
determining how agents will be rewarded for their efforts. Rewards are to be
based on economic quantities of interest to principals, such as returns on
capital employed. According to this perspective, the management process
mainly involves acquiring and deploying assets and, to influence this
process, principals must establish a consistent set of delegated decisions
(grants of authority to acquire assets), performance measures (resulting from
the use of assets by agents), and rewards (incentives for the agent to
acquire and utilize assets in the principal's interests).

Page 3

Prepared By: Chetan Bhagwath

In responsibility budget formulation, an organization's policies, the results of
all past policy (capital budgeting) decisions, are converted into financial
targets that correspond to the domains of administrative units and their
managers. In responsibility budget execution, operating performance is
monitored and subordinate managers are evaluated and rewarded.
Operating performance targets must be expressed in financial terms. This
makes it possible to make comparisons across unlike responsibility centers,
thereby permitting the relative performance of managers to be evaluated
and increasing the motivational efficacy of internal competition. In traditional
responsibility budgets this also has the effect of keeping higher levels of
administration ignorant of operating details, thereby discouraging them from
meddling in the affairs of their responsibility center managers.
Governance Arrangements, Administrative Processes, Contractual
Relationships
All governance arrangements and administrative processes are primarily
mechanisms for motivating and inspiring people to serve the policies and
purposes of the organizations to which they belong. This means that all
governance arrangements and all administrative processes can be treated as
relationships and that administrative design and implementation can be
thought of as negotiating and maintaining those relationships.
One way of describing relationships uses contractual language and talks
about principals and agents. This language implies a hierarchical
relationship, in which a nominal subordinate (agent) serves the purposes of a
superior (principal). On the presumption that behavior is largely selfinterested, principal-agent relationships are problematic (give rise to agency
costs) only where (a) the efforts of the agent cannot be perfectly observed;
(b) the interests of agent and principal diverge; and (c) agents pursue their
own interests, i.e., behave opportunistically.
One of the key goals of governance arrangements and administrative
processes is the minimization of agency costs. Of course, agency costs also
include all resources used to reduce divergences of interest, i.e., identifying
collectively beneficial relationships, negotiating contributions, and devising
procedures for monitoring performance and sanctioning defectors. Included
here are a whole panoply of activities extending from the employment of
security guards to the design and implementation of new or reconfigured
accounting and reporting systems. Hence, minimizing agency costs means
minimizing the sum of costs that result from opportunistic behavior plus the
Page 4

costs of avoiding or controlling that behavior. Economic theory tells us that

we find this optimum where the marginal costs of controls equal their
marginal benefits, as shown in Figure 1.1

Prepared By: Chetan Bhagwath

Traditional or Weberian bureaucracies rely on rules to govern or prevent

opportunistic behavior. In other words, principals specify in detail what
agents must do (or must not do), carefully monitor their actions, and
sanction all deviations accordingly. The problem with this approach is that
agents often have better information about some things than do principals.
Principals hire agents because of their superior expertise and to spare
themselves the burden of being perfectly informed about every aspect of an
organization's operations. In neither case will principals have the knowledge
needed to specify in detail what the agent should do without thereby
sacrificing performance. This means that rules are not always a wholly
satisfactory solution to the principal-agent problem. It is this fact that makes
the application of agency theory to the public sector especially important, for
it is in the public sector that the opportunity costs arising from detailed rules
often seem highest.

Page 5

Prepared By: Chetan Bhagwath

Types of Responsibility Centers

The agency theory view lends itself to a description of responsibility centers
in terms of the authority of managers to acquire assets and the kinds of
financial targets that would align responsibility with authority:

Discretionary expense center managers are accountable for

compliance with an asset acquisition plan (expense budget). They have
no independent authority to acquire assets. Their superiors must
authorize each acquisition. Managerial accountants generally believe
that a unit should be set up as a discretionary expense center only
where there is no satisfactory way to match its expenses to final cost
objects. Most governmental organizations are discretionary cost
centers.
Cost center managers are responsible for producing a stated quantity
and/or quality of output at the lowest feasible cost. Someone else
within the organization determines the output of a cost center
&emdash; usually including various quality attributes, especially
delivery schedules. Cost center managers are free to acquire shortterm assets (those that are wholly consumed within a performance
measurement cycle), to hire temporary or contract personnel, and to
manage inventories.
1. In a standard cost center, output levels are determined by
requests from other responsibility centers and the manager's
budget for each performance measurement cycle is determined
by multiplying actual output by standard cost per unit.
Performance is measured against this figure &emdash; the
difference between actual costs and the standard.
2. In a quasi-profit center, performance is measured by the
difference between the notational revenue earned by the center
and its costs. For example, let's say an air logistics center rebuilt
500 F-16 jet engines and 200 F-15 engines for the Air Combat
Page 6

Command. The notational revenue earned was $2.5 million per F16 (500) = $1.25 billion and $5 million per F-15 (200) = $1
billion, or $2.25 billion total. If the logistics center's operating
costs (including non cash expenses such as depreciation of plant
and equipment and imputed rents) were $1.8 billion, it would
earn a quasi-profit of $425 million ($2.25 billion - $1.8 billion).
These notational revenues (or transfer prices) usually reflect
historical costs or market prices.

Profit center managers are responsible for both revenues and costs.
Profit is the difference between revenue and cost. Thus, profit center
managers are evaluated in terms of both the revenues their centers
earn and the costs they incur.

In addition to the authority to acquire short term assets, to hire

temporary or contract personnel, and to manage inventories, profit
center managers are usually given the authority to make long term
hires, set salary and promotion schedules (subject to organization wide
standards), organize their units, and acquire long lived assets costing
less than some

Prepared By: Bhavesh Joshi

specified amount. Note, however, real revenue can be earned only on

sales outside the organization -- AFMC's sales of services to foreign
governments and private firms earns revenue, for example; services
performed for other elements of the Air Force would merely earn
notational revenues or transfer prices.

Investment center managers are responsible for both profit and the
assets used in generating profit. Thus, an investment center adds more
to a manager's scope of responsibility than does a profit center, just as
a profit center involves more than a cost center. Investment center
managers are typically evaluated in terms of return on assets (ROA),
which is the ratio of profit to assets employed, where the former is
expressed as a percentage of the latter. In recent years many have
turned to economic value added (EVA), net operating "profit" less an
appropriate capital charge, which is a dollar amount rather than a
ratio. If, for example, the logistics center described earlier had assets
of $7.5 billion ($5 billion in fixed assets and $2.5 in current assets,
primarily work-in-progress and parts inventories) and the federal
government's cost of capital were 5 percent, its quasi-EVA would have
been $50 million ($425 million - $375 million); its ROA would have
been 5.7 percent.

A Strategic Management Perspective on Responsibility Budgeting

and Accounting
Page 7

The practice has also been described in terms of organizational design and
strategic management. In these terms, responsibility budgeting and
accounting takes place within an organizational configuration known as an Mform, where decisional authority over strategy formulation is reserved to top
management, while decisional authority over strategy implementation is
decentralized to business units headed by general managers (Mintzberg
1983).
From the management strategy perspective, a responsibility budget is
merely an artifact of the management process conducted within such a
structural set up. Specifically, the responsibility budget formalizes a
performance target for a given business unit over a specified time scale. In
the typical case, goals are expressed in terms of economic quantities that
reflect the utilization of resources and the financial results obtained as well
as other scorecard measures. Responsibility accounting systems are set up
to produce these measures so that divisional performance can be compared
with targets in a timely manner and, where necessary, adjusted. Because
business strategies are usually conceived along product-market lines (single
product, differentiated products, multiple products) and because the M-form
structures provide a general manager for each product line (rather than for
regions or functions), in the management control and strategic management
literatures, responsibility budgeting and accounting is broadly endorsed as
the mode of organizing and managing large, multiproduct firms whose
outputs are by definition heterogeneous.

Prepared By: Bhavesh Joshi

Diagnostic versus Interactive Control

Under traditional responsibility budgeting and accounting systems, top
management exercises control "by the numbers" from a small corporate
headquarters, using financial targets, which it sets for the operating
divisions. Robert Simons (1995: 102) refers to this kind of control as
diagnostic control. Diagnostic control severely restricts the upward flow of
operating information within organizations &emdash; making
decentralization a necessity as well as an ideal.
This approach, however, is based on the assumption managers know how to
improve performance. Hence, as Bob Behn observes," all that is required is
to give them either (a) the correct incentives or (b) the necessary flexibility,
and they will do it &emdash; they will just know what managerial actions will
be most effective in improving performance." Unfortunately, managers don't

Page 8

necessarily know what to do. Consequently, he suggests that "maybe we

also need a help-the-managers-manage strategy" (Behn 2003: 2).
An alternative to diagnostic control or control by the numbers is control by
debate and dialogue, what Simons calls interactive control. Control by
debate and dialogue is a help-the-manager-manage strategy. It is by design a
learning process, proceeding from strategic vision through choices and their
consequences to better understanding, clearer vision, improved choices, and
higher valued consequences. Simons observes that both diagnostic control
and interactive control are consistent with the practice of decentralization.
However, decentralization is possible under diagnostic control only where top
management attends to top management functions and refrains from
meddling in the conduct of operations. This takes considerable self-restraint.
Nevertheless, Simon argues that the best-managed, decentralized
organizations are precisely those where less emphasis is given to meeting
financial targets per se than to the effectiveness with which operating
managers engage in reflective argumentative exchange and where target
setting is a bottom-up process. To meet the burden of argument in this
context, operating managers must persuade their superiors that they fully
understand every aspect of their businesses &emdash; costs, trends,
operating efficiency, marketing strategy, competitive position &emdash; and
that their action plans and programs will realize the larger organizational
purpose or interest.
The other Axis of Responsibility Center Design
Responsibility centers are usually classified according to a second axis or
dimension:

The integration axis -- i.e., the relationship between the responsibility

center's objectives and the overall purposes and policies of the
organization;

Prepared By: Viral Desai

On this axis, a responsibility center can be either a mission center or a

support center. The output of a mission center contributes directly to an
organization's objectives or purpose. The output of a support center is an
input to another responsibility center in the organization, either another
support center or a mission center.
Formerly, in most large complex organizations in the private sector,
individual production units were typically standard cost centers; staff units
were typically discretionary expense centers. Indeed, only mission centers
Page 9

were allowed to be investment centers. The reasons for this are complex, but
they go to difficulties associated with expensing intermediate and joint
products. Mission centers in private sector organizations produce final
products that are easily priced and that are expensed following generally
accepted accounting practice. In contrast, support centers produce
intermediate products and these were, until recently, hard to cost, let alone
price, with accuracy. Attempts to do so were often either excessively
arbitrary or prohibitively costly.

Nowadays, however, advances in information technology, managerial

accounting, and organizational design have made it possible and, in some
cases, beneficial to treat every responsibility center in an organization as an
investment center.
Paradoxically, public sector organizations are a mirror image of large
complex organizations in the private sector. We know now how to treat
support centers in most organization as quasi-profit or even investment
centers. But, because the final products of government's core mission
centers are public goods that are passively enjoyed, pricing final outputs
remains for the time being and for the foreseeable future either excessively
arbitrary or prohibitively costly. This means, for example, that, while it might
make sense to treat services with direct commercial counterparts such as
military depot maintenance, spare parts management, or facilities support
centers as investment centers, it will continue to be necessary to treat the
armed forces' combatant commands as discretionary expense centers.
Prepared By: Viral Desai

Fortunately, as far as exhaustive expenditures are concerned, about 75

percent of the activities performed by the US federal government fall into the
Page 10

support category and, for the most part, state and local governments are not
in the business of supplying pure public goods.

Prepared By: Viral Desai

Transfer Pricing

Page 11

Under responsibility budgeting, support centers provide services or

intermediate goods to other responsibility centers in return for a notational
transfer price, organizations are structured to take advantage of specialized
knowledge and local conditions, center managers make decisions and are
held responsible for the overall financial performance of their centers. Sound
transfer pricing is, therefore, the key to aligning the incentives of
responsibility center managers with organizational interests.
Transfer pricing is also important to transparency within organizations. It
helps to determine the costs of services provided by one unit to another,
which is central to measuring performance relative to a financial target, and
therefore plays a major role in establishing, as well as manipulating, the
incentives facing responsibility center managers. Transfer pricing also
reveals the internal costs of service decentralization where costs are incurred
in transferring decision rights to others within an organization. When one
sub-unit transfers tangible assets, knowledge, skills, etc., to another, both
units calculate the cost as a means of revealing their liquid and tangible
asset use internally and in external provision of service.
There are two common approaches to transfer pricing:

Laissez-faire transfer pricing: buying and selling responsibility centers

are completely free to negotiate prices, to deal, or not to deal; and
Marginal or incremental cost pricing: the responsibility center selling
the service is required to charge the buying responsibility center
whichever is less of market or incremental cost.

(A third method is based upon fully distributed average cost of the service or
product.)
However, the circumstances that justify large complex organizations -economies of scale and scope -- render these simple transfer-pricing
mechanisms problematic. Scale economies are usually the result of large,
lumpy investments in specialized resources -- technological knowledge,
product specific research and development, or equipment. These
investments tend to give rise to bilateral monopoly, a circumstance that
provides an ideal environment for opportunistic behavior on the part of
suppliers and customers. For example, once an intermediate product
producer has acquired a specialized asset, customers may be able to extract
discounts by threatening to switch suppliers. In that case, the supplier may
find it necessary to write off a large part of the specialized investment. Or, if
demand for the final good increases greatly, the intermediate product
supplier may be able to extort exorbitant prices from customers. Hence,
where the relationship between intermediate product supplier and customer
is at arm's length, opportunistic behavior may eliminate the payoff to what
would otherwise be cost effective investments.
Page 12

Prepared By: Nishit Shetty

For example, the Report of the Commission on Roles and Missions of the
Armed Forces (Commission, 1995; see also Thompson & Jones, 1994)
suggested that budget authority should flow through the combatant
commands to the military departments. Were that the case, lacking a longterm credible commitment on the part of the Joint Chiefs and the combatant
commanders, the navy's investment in specialized assets like aircraft carriers
would permit it to be exploited in peacetime. In wartime, of course, the
tables would be turned.
The new economics of organizations tells us that vertical integration occurs
because it can mitigate this problem, in part through the substitution of
direct supervision for remote control (see Williamson, 1985). For example, in
a study of military procurement, Scott Masten (1984) demonstrated that
specialized investments are critical to vertical integration. Where
intermediate products were both complex and highly specialized (used only
by the buyer), there was a 92 percent probability that they would be
produced internally; even 31 percent of all simple, specialized components
were produced internally. The probability dropped to less than 2 percent if
the component was unspecialized, regardless of its complexity.
Unfortunately, the problems that arise in arm's length transactions where
there are few alternative suppliers/customers also arise where one attempts
to replicate free market forces within the organization, allowing buying and
selling responsibility centers complete freedom to negotiate prices (laissezfaire transfer pricing). Traditionally, economists have argued that services
should be transferred at marginal or incremental cost to the buying
responsibility center. But this can seriously distort the evaluation of support
center performance and tend to eliminate incentives to improvement.
As a result, organizations face a serious dilemma. They can maximize short
run performance by using marginal cost in internal transactions, thereby
seriously distorting performance measurement and incentives, which will
cause shortfalls in long-run performance. Or they can sacrifice short-term
performance by relying on laissez-faire transfer pricing, thereby obtaining
superior measures of the support center's contributions to organizational
performance, and improve the chances of maximizing performance in the
long term. Organizations can, promote short-run performance by using
incremental cost pricing or they can promote long-term performance by
using laissez-faire pricing, but they cannot do both simultaneously using
either of these simple transfer pricing mechanisms.

Page 13

In theory, bilateral monopoly can be governed quite satisfactorily by

unbalanced transfer prices, multi-part transfer prices, or quasi-vertical
integration. Under unbalanced transfer prices, the selling responsibility
center is credited with the full cost of the transacted item (often standard
cost), plus an agreed upon markup, the buying center is charged its marginal
cost, and the organizations accounts are adjusted to reflect the difference
between the two.
Prepared By: Nishit Shetty

Unbalanced transfer prices are rarely used, however, where market prices
are available. Under, multi-part transfer prices, the service delivered is
decomposed to reflect underlying cost drivers and priced accordingly (your
home phone bill is an excellent example of a multi-part tariff). Under quasivertical integration, the buyer invests in specialized resources and loans,
leases, or rents them to their suppliers. Quasi-vertical integration is common
in both the automobile and the aerospace industries, and, of course, it is
standard procedure for the Department of Defense to provide and own the
equipment, dies, and designs that defense firms use to supply it with
weapons systems and the like (See Monteverde & Teece, 1982). Other
organizations that rely on a small number of suppliers or a small number of
distributors write contracts that constrain the opportunistic behavior of those
with whom they deal.
In still other cases, desired outcomes can be realized through alliances based
on the exchange of hostages (e.g., surety bonds, exchange of debt or equity
positions) or just plain old-fashioned trust based on long-term mutual
dependence. Toyota, for example, relies on a few suppliers that it nurtures
and supports (Womack, Jones, Roos, 1990). They have substantial crossholdings in each other and Toyota often acts as its suppliers' banker. Toyota
maintains tight working links between its manufacturing and engineering
departments and its suppliers, intimately involving them in all aspects of
product design and manufacture. Indeed, it often lends them personnel to
deal with production surges and its suppliers accept Toyota people into their
personnel systems.
Toyota's suppliers are not completely independent companies with only a
marketplace relationship to each other. In a very real sense, they all share a
common purpose and destiny. Yet Toyota has not integrated its suppliers into
a single, large bureaucracy. It wanted its suppliers to remain independent
companies with completely separate books -- real profit/investment centers,
rather than merely notational ones -- selling to others whenever possible.
Toyota's solution to the bilateral monopoly problem appears to work just fine.
In fact, with the exception of unbalanced transfer prices, none of the
Page 14

solutions to the bilateral monopoly problem noted here presumes vertical

integration. All that is required is full access to cost and production
information. Of course, all of these solutions to the transfer
pricing/organizational design are potentially available to government
organizations. Indeed, many of them were pioneered by federal acquisitions
personnel or imposed by public utility commissions. They are not, however,
widely understood or appreciated by public administrators and financial
managers.

Prepared By: Nishit Shetty

Developing Responsibility Budgets

Responsibility Accounting
Responsibility accounting is an underlying concept of accounting
performance measurement systems. The basic idea is that large diversified
organizations are difficult, if not impossible to manage as a single segment,
thus they must be decentralized or separated into manageable parts. These
parts, or segments are referred to as responsibility centers which include: 1)
revenue centers, 2) cost centers, 3) profit centers and 4) investment centers.
This functional approach allows responsibility to be assigned to the segment
managers that have the greatest amount of influence over the key elements
to be managed. These elements include revenue for a revenue center (a
segment that mainly generates revenue with relatively little costs), costs for
a cost center (a segment that generates costs, but no revenue), a measure
of profitability for a profit center (a segment that generates both revenue
and costs) and return on investment (ROI) for an investment center (a
segment such as a division of a company where the manager controls the
acquisition and utilization of assets, as well as revenue and costs).
Advantages and Disadvantages
Responsibility accounting has been an accepted part of traditional
accounting control systems for many years because it provides an
organization with a number of advantages. Perhaps the most compelling
argument for the responsibility accounting approach is that it provides a way
Page 15

to manage an organization that would otherwise be unmanageable. In

addition, assigning responsibility to lower level managers allows higher level
managers to pursue other activities such as long term planning and policy
making. It also provides a way to motivate lower level managers and
workers. Managers and workers in an individualistic system tend to be
motivated by measurements that emphasize their individual performances.
However, this emphasis on the performance of individuals and individual
segments creates what some critics refer to as the "stovepipe organization."
Others have used the term "functional silos" to describe the same idea.7
Consider Exhibit 9-6. Individuals in the various segments and functional
areas are separated and tend to ignore the interdependencies within the
organization. Segment managers and individual workers within segments
tend to compete to optimize their own performance measurements rather
than working together to optimize the performance of the system.

Prepared By: Nishit Shetty

Page 16

Summary and Controversial Question

An implicit assumption of responsibility accounting is that separating a
company into responsibility centers that are controlled in a top down manner
is the way to optimize the system. However, this separation inevitably fails to
consider many of the interdependencies within the organization. Ignoring the
interdependencies prevents teamwork and creates the need for buffers such
as additional inventory, workers, managers and capacity. Of course, a system
that prevents teamwork and creates excess is inconsistent with the lean
enterprise concepts of just-in-time and the theory of constraints. For this
reason, critics of traditional accounting control systems advocate managing
the system as a whole to eliminate the need for buffers and excess. They
also argue that companies need to develop process oriented learning support
systems, not financial results, fear oriented control systems. The information
system needs to reveal the company's problems and constraints in a timely
manner and at a disaggregated level so that empowered users can identify
how to correct problems, remove constraints and improve the process.
According to these critics, accounting control information does not qualify in
any of these categories because it is not timely, disaggregated, or user
friendly.
Page 17

Prepared By: Nishit Shetty

This harsh criticism of accounting control information leads us to a very

important controversial question. Can a company successfully implement
just-in-time and other continuous improvement concepts while retaining a
traditional responsibility accounting control system? Although the jury is still
out on this question, a number of field research studies indicate that
accounting based controls are playing a decreasing role in companies that
adopt the lean enterprise concepts. In one study involving nine companies,
each company answered this controversial question in a different way by
using a different mix of process oriented versus results oriented learning and
control information. Since each company is different, a generalized answer to
this question for all firms in all situations cannot be given in a textbook.
However, a great deal more information is provided in the next chapter to
help you answer this question for the companies you are likely to encounter
in practice. This chapter concentrates on the planning aspects of budgeting,
while the next chapter addresses the control methodology

Page 18

Prepared By: Nishit Shetty

The Operating Budget

Preparing an Operating Budget is a sequential process of developing nine
sub-budgets. Except for one or two exceptions the sub-budgets must be
prepared in the following order: sales, production, direct materials, direct
labor, factory overhead, ending inventory, cost of goods sold, selling &
administrative and income statement (see Exhibit 9-4). Each part is
described below.
1. SALES BUDGET
Developing a sales budget involves the following calculations:
Budgeted Sales $ = (Budgeted Unit Sales)(Budgeted Sales Prices)
Current Period Cash Collections = Current Period Cash Sales + Current
Period Credit Sales Collected in Current Period + Prior Period Credit
Sales Collected in Current Period
These calculations are relatively simple, but where does the budget director
obtain this information? Well, sales forecasting is a marketing function. Sales
estimates are frequently generated by the company's sales representatives
who discuss future needs with customers (wholesalers and retailers).
Statistical forecasting techniques can also be used to make estimates of
expected future sales, considering the company's previous sales
performance and various assumptions about the future economic climate,
and the actions of competitors and consumers. Pricing is also a marketing
function, but many prices are based on costs plus a markup (the supply
function) and consideration of what consumers are willing and able to pay for
the product (the demand function). Thus, the budgeted sales price is usually
determined after the budgeted unit cost has been calculated (see 6b. below).
The information needed to develop an equation for collections is provided by
the finance department and is normally based on past experience. These
calculations are somewhat more involved than they appear to be in the
equation above because of the effects of cash discounts and the time lags
between credit sales and collections. Cash discounts are frequently used to
speed up cash inflows. This puts the funds back to work sooner and reduces
the need for short term loans. However, even with a generous cash discount
Page 19

for prompt payment, collections for credit sales are typically spread out over
several months. The examples illustrated below provide some of the
possibilities.

Prepared By: Amol Naik

2. PRODUCTION BUDGET
Preparing a production budget includes consideration of the desired
inventory change as follows:
Units To Be Produced = Budgeted Unit Sales (from 1) + Desired Ending
Finished Goods - Beginning Finished Goods
The desired ending inventory is usually based on the next periods sales
budget. Considerations involve the time required to produce the product,
(i.e., cycle time or lead time) as well as setup costs and carrying costs. In a
just-in-time environment the desired ending inventory is relatively small, or
theoretically zero in a perfect situation. In the examples and problems in this
chapter, the ending finished goods inventory is stated as a percentage of the
next period's (month's) unit sales.
3. DIRECT MATERIAL BUDGET
The direct materials budget includes five separate calculations.
a. Quantity of Material Needed for Production = (Units to be Produced)
(Quantity of Material Budgeted per Unit)
The quantity of material required per unit of product is determined by the
industrial engineers who designed the product. Materials requirements are
frequently described in an engineering document referred to asa "bill of
materials".
b. Quantity of Material to be Purchased = Quantity of Material Needed
for Production + Desired Ending Material - Beginning Material
This calculation is more involved than equation 3b appears to indicate
because it includes information for two future periods. The desired ending
materials quantity is normally based on the next period's (month's) materials
Page 20

needed for production and this amount depends on the third period's
budgeted unit sales. Of course inventories of raw materials (just like finished
goods) are kept to a minimum in a JIT environment. Factors that influence the
desired inventory levels include the reliability of the company's suppliers, as
well as ordering and carrying costs.
c. Budgeted Cost of Material Purchases = (Quantity of Material to be
Purchased)(Budgeted Material Prices)

Prepared By: Amol Naik

This amount is needed to determine cash payments. Once the quantity to be

purchased has been determined, the cost of purchases is easily calculated.
Budgeted material prices are provided by the purchasing department.
d. Cost of Material Used = (Quantity needed for Production)(Budgeted
Material Prices)
The cost of materials used is needed in the cost of goods sold budget below.
e. Cash Payments for Direct Material Purchases = Current Period
Purchases Paid in Current Period + Prior Period Purchases Paid in Current
Period
The information needed to determine budgeted cash payments is provided
by accounting, (accounts payable) and is usually based on past experience.
Normally the budget should reflect a situation where the company pays
promptly to take advantage of all cash discounts allowed, thus 3e may be
equal to 3c.
4. DIRECT LABOR BUDGET
Fewer calculations are needed for direct labor than for direct materials
because labor hours cannot be stored in the inventory for future use. Time
can be wasted, but not postponed.
a. Direct Labor Hours Needed For Production = (Units to be Produced)
(D.L. Hours Budgeted per Unit)
The amount of direct labor time needed per unit of product is determined by
industrial engineers. Estimates are frequently made using a technique
referred to as motion and time study. This involves measuring each
Page 21

movement required to perform a task and then assigning a precise amount

of time allowed for these movements. The cumulative time measurements
for the various tasks required to produce a product provide the estimate of a
standard time per unit. There are alternative techniques that are less
expensive, but motion and time study provides estimates that are very
precise. Learning curves provide another quantitative technique that is
helpful in establishing labor standards.
b. Budgeted Direct Labor Cost = (D.L. Hours needed for Production)
(Budgeted Rates Per Hour)
The budgeted rates per hour for direct labor are provided by the human
resource department. Frequently the labor (union) contract provides the
source for this information. Many different types of labor may be required
with different levels of expertise and experience. Thus, Equations 4a and 4b
may include several calculations.
Prepared By: Amol Naik

5. THE FACTORY OVERHEAD BUDGET

The factory overhead budget is based on a flexible budget calculation as
described in Exhibit 9-3. More specifically, the calculation is as follows:
a. Budgeted Factory Overhead Costs = Budgeted Fixed Overhead +
(Budgeted Variable Overhead Rate)(D.L. Hours needed for Production
from 4a)
This is a cumulative equation that combines the equations for the company's
various types of indirect resources. This same idea was illustrated in Chapter
4 when introducing predetermined overhead rates. The predetermined
overhead rates developed in Chapter 4 and the budgeted overhead rates
discussed in this chapter are conceptually the same.
A plant wide rate based on direct labor hours is used as the overhead
allocation basis in this chapter and subsequent chapters mainly to simplify
the illustrations. Keep in mind however, that although many companies are
still using a single production volume based measurement for overhead
allocations, most companies use departmental rates and many companies
are now using activity based rates.
The calculation for cash payments reflects one of the differences between
cash flows and accrual accounting. Since some costs, like depreciation, do
not involve cash payments in the current period, these costs must be
subtracted from the total overhead costs to determine the appropriate
amount.
Page 22

b. Cash Payments for Overhead = Budgeted Factory Overhead Cost Depreciation and other costs that do not require cash payments

Alternative Calculation for Budgeted Factory Overhead Costs

Although budgeted factory overhead costs can be calculated in the manner
presented above, there is an alternative approach that illustrates the
difference between budgeted and standard costs. Budgeted factory overhead
costs can be calculated by determining the standard factory overhead costs
and then adjusting for the planned production volume variance. The planned
production volume variance is similar to the capacity (or idle capacity)
variance illustrated in Chapter 4. It is the difference between the
denominator inputs used to calculate the overhead rates, i.e., direct labor
hours in our example, and the budgeted direct labor hours needed for
production, multiplied by the budgeted fixed overhead rate.

Prepared By: Melwyn Gonsalves

The alternative calculation for factory overhead costs is:
Budgeted factory overhead costs = (Total budgeted overhead rate per
hour)(D.L. hours needed for production from 4a)
+ Unfavorable planned production volume variance or - Favorable
planned production volume variance
Multiplying the total overhead rate by the number of direct labor hours
needed for production provides the standard or applied overhead costs.
However, if the number of direct labor hours needed for planned production
(i.e., budgeted hours) is not equal to the number of hours used to calculate
the overhead rates (i.e., denominator hours), then standard fixed overhead
costs will not be equal to budgeted fixed overhead costs. The difference is
the planned production volume variance. This is illustrated graphically in
Figure 9-1.

Page 23

Prepared By: Melwyn Gonsalves

Since the difference is caused by the way fixed overhead costs are treated, it
can be illustrated by comparing standard fixed overhead costs with budgeted
fixed overhead costs. Figure 9-1 shows that if planned or budgeted hours
(BH1) are less than denominator hours (DH), the planned production volume
variance (PPVV) is unfavorable and represents underapplied fixed overhead.
However, if planned or budgeted hours (BH2) are greater than denominator
hours (DH), then the planned production volume variance (PPVV) is favorable
and represents overapplied fixed overhead.
The difference between budgeted and standard total factory overhead costs
can be illustrated by simply adding variable overhead costs to the graph.
Since budgeted and standard variable overhead costs are always equal at
any level of production, the difference between standard and budgeted total
Page 24

overhead costs is the same as the difference between standard and

budgeted fixed overhead costs. The difference is the planned production
volume variance. This is illustrated in Figure 9-2

Prepared By: Melwyn Gonsalves

Summary of the PPVV Concept

At any particular level of production, e.g., 1,000 hours, budgeted and
standard variable overhead costs are always equal. However, budgeted and
standard fixed overhead costs are only equal when the budgeted hours
planned for the month are equal to the denominator hours used to calculate
the overhead rates. The difference between the budgeted hours planned and
the denominator hours, multiplied by the fixed overhead rate is the
difference between budgeted and standard fixed overhead costs as well as
Page 25

the difference between budgeted and standard total overhead costs. When
working with a budget this difference is referred to as the planned production
volume variance.
6. ENDING INVENTORY BUDGET
The dollar amount for the ending inventory of finished goods is needed below
to determine cost of goods sold. The dollar amounts for ending direct
materials and finished goods are needed for the balance sheet.
a. Ending Direct Materials = (Desired Ending Materials from 3b)
(Budgeted Prices)
b. Budgeted or Standard Unit Cost = (Quantity of D.M. required per
Unit)(Budgeted Prices) + (D.L. Hours required per Unit)(Budgeted Rate)
+ (Total Overhead Rate)(D.L. Hours required per Unit)
The budgeted or standard unit cost can be calculated at any time after the
budgeted quantities per unit and input prices are obtained. The calculation is
placed here because it is needed for 6c.
c. Ending Finished Goods = (Desired Ending Finished Goods from 2)
(Budgeted Unit Cost)
7. COST OF GOODS SOLD BUDGET
Cost of goods sold is needed for the income statement. One method of
determining budgeted COGS involves accumulating the amounts from the
previous sub-budgets as follows.
a. Budgeted Total Manufacturing Cost = Cost of Direct Material Used
(from 3d.) + Cost of Direct Labor Used (from 4b.)
+ Total Factory Overhead Costs (from 5a.)

Prepared By: Melwyn Gonsalves

b. Budgeted Cost of Goods Sold = Budgeted Total Manufacturing Cost
(from 7a.) + Beginning Finished Goods (from previous ending or
calculate from 2 and 6b) - Ending Finished Goods (from 6c or calculate
from 2 and 6b)
This is the same approach used in Chapter 2 to determine cost of goods sold,
but when developing a budget we typically assume no change in Work in

Page 26

Process. Therefore, budgeted cost of goods manufactured is equal to

budgeted cost of goods sold.
Alternative Calculation for Budgeted Cost of Goods Sold
Budgeted cost of goods sold can also be calculated by determining standard
cost of goods sold, and then adjusting for the planned production volume
variance. The alternative calculation for cost of goods sold is:
Budgeted Cost of Goods Sold = (Budgeted unit sales)(Budgeted unit
cost)
+ Unfavorable planned production volume variance
or - Favorable planned production volume variance
Although budgeted unit cost equals standard unit cost, budgeted cost of
goods sold is not equal to standard cost of goods sold. Again, the difference
between standard and budgeted costs is the production volume variance.
There are two reasons to become familiar with this alternative. First, it helps
strengthen your understanding an important concept that appears again in
subsequent chapters, e.g., Chapters 10 and 12. A second reason is that the
alternative approach provides a much faster way to calculate budgeted cost
of goods sold. Therefore it can be used as a stand alone method, or as a way
to check the accuracy of your calculations in 7a and b.
You may wonder why a company would plan a production volume variance in
the budget. This occurs because the denominator activity for a particular
month is normally the average monthly production based on one twelfth of
the planned production for the entire year. The denominator may also be an
average based on normal, practical, or theoretical maximum capacity for the
year. When the planned production for a particular month is higher or lower
than the monthly average, a planned production volume variance results.
Actual production volume variances also occur as we shall see in the next
chapter.
8. SELLING & ADMINISTRATIVE EXPENSE BUDGET
The preparation of the selling and administrative expense budgets is very
similar to the approach used for factory overhead.

Prepared By: Melwyn Gonsalves

a. Budgeted Selling and Administrative Expenses = Budgeted Fixed
Selling & Administrative Expenses + (Bud Variable Rate as a Proportion
of Sales $)(Budgeted Sales $)
Page 27

b. Cash Payments for Selling & Administrative Expenses = Budgeted

Selling & Administrative Expenses - Depreciation and other cost which
do not require cash payments
Although we will place less emphasis on this part of the master budget,
(mainly to simplify the illustrations) these costs are usually significant. Also
remember that many appropriation budgets (treated as fixed costs) may be
included, particularly for certain administrative costs. In addition, as pointed
out earlier in the text, a more precise traceable costing approach might be
used for management purposes where some selling and administrative costs
are allocated (i.e., traced to products) in determining a more precise product
cost. Remember however, that selling and administrative costs are treated
as expenses (period costs) in the conventional inventory valuation methods.
9. BUDGETED INCOME STATEMENT
Preparing the budgeted income statement involves combining the relevant
amounts from the sales, cost of goods sold and selling & administrative
expense budgets and then subtracting interest, bad debts and income taxes
to obtain budgeted net income. These amounts are provided by the finance
department. In a comprehensive practice problem, the applicable amount for
interest expense may need to be calculated from information associated with
the cash budget. Bad debt expense is based on the expected proportion of
uncollectable stated in the information related to cash collections.

a. Budgeted Sales $ - Budgeted Cost of Goods Sold = Budgeted Gross

Profit
b. Budgeted Gross Profit - Budgeted Selling & Administrative Expenses
= Operating Income
c. Operating Income - Interest Expense - Bad Debts Expense = Net
Income Before Taxes
d. Net Income Before Taxes - Income Taxes = Net Income After Taxes

Prepared By: Melwyn Gonsalves

The Financial Budget

Page 28

The financial budget includes the cash budget, the capital budget and the
budgeted balance sheet. The cash budget, budgeted balance sheet & Capital
budget are discussed below.
CASH BUDGET:
-The cash budget is prepared after the operating budgets (sales,
manufacturing expenses or merchandise purchases, selling expenses, and
general and administrative expenses) and the capital expenditures budget
are prepared.
-The cash budget starts with the beginning cash balance to which is added
the cash inflows to get cash available.
-Cash outflows for the period are then subtracted to calculate the cash
balance before financing. If this balance is below the company's required
balance, the financing section shows the borrowings needed.
-The financing section also includes debt repayments, including interest
payments. The cash balance before financing is adjusted by the financing
activity to calculate the ending cash balance.
-The ending cash balance is the cash balance in the budgeted or pro forma
balance sheet.
BUDGETED BALANCE SHEET
Preparing the budgeted balance sheet involves accumulating information
from the previous periods balance sheet, the various operating sub-budgets,
the cash budget and other accounting records.
ASSETS
a. Current Assets:
Cash (from the cash budget 10c)
Accounts Receivable (from the sales budget and previous balance
sheet)
Direct materials (from the ending inventory budget 6a)
Finished goods (from the ending inventory budget 6c)
b. Long Term Assets:
Land (from previous balance sheet and budgeted activity)
Buildings (from previous balance sheet and budgeted activity)

Prepared By: Kamlesh Damania

Page 29

Equipment (from previous balance sheet and budgeted activity)

Accumulated depreciation (from the accounting records)
LIABILITIES
c. Current Liabilities:
Accounts Payable (from various operating sub-budgets)
Taxes Payable (from income statement)
d. Long term Liabilities:
Notes payable
Bonds payable
Convertible bond
Capital Lease obligation
Post retirement benefit obligations
Other accrued expenses.
SHAREHOLDERS EQUITY
e. Common Stock (from previous balance sheet and budgeted activity)
f. Retained Earnings (from previous balance sheet and income
statement)
Total Shareholders Equity
Total Liabilities and Shareholders Equity.
Capital Budget: Capital budgeting is vital in marketing decisions. Decisions
on investment, which take time to mature, have to be based on the returns
which that investment will make. Unless the project is for social reasons only,
if the investment is unprofitable in the long run, it is unwise to invest in it
now.
The classification of investment projects
a) By project size
Small projects may be approved by departmental managers. More careful
analysis and Board of Directors' approval is needed for large projects of, say,
half a million dollars or more.

Page 30

Prepared By: Kamlesh Damania

b) By type of benefit to the firm

an increase in cash flow
a decrease in risk
an indirect benefit (showers for workers, etc).
c) By degree of dependence
mutually exclusive projects (can execute project A or B, but not both)
complementary projects: taking project A increases the cash flow of

project B.
substitute projects: taking project A decreases the cash flow of project
B.
d) By degree of statistical dependence
Positive dependence
Negative dependence
Statistical independence.

Page 31

Prepared By: Kamlesh Damania

Budgeting with MBO System

Management by objectives (MBO) is a process of defining
objectives within an organization so that management and
employees agree to the objectives and understand what they
need to do in the organization in order to achieve them. The
term "management by objectives" was first popularized by
Peter Drucker in his book The Practice of Management in 1954.
The essence of MBO is participative goal setting, choosing course
of actions and decision making. An important part of the MBO is the
measurement and the comparison of the employees actual
performance with the standards set. Ideally, when employees
themselves have been involved with the goal setting and choosing the
course of action to be followed by them, they are more likely to fulfill
their responsibilities.
Management by objectives can also be described as a process whereby
the superior and subordinate jointly identify its common goals, define
each individual's major areas of responsibility in terms of the results
expected of him, and use these measures as guides for operating the
unit and assessing the contribution of each of its members.
Responsibility Center Management

Known as RCM, it is the managerial framework for our internal

budgeting and financial reporting activities
There are two basic types of Centers: Revenue-generating and Nonrevenue-generating.
Revenue-generating centers are expected to:
o

fund the direct cost of their own operations

cover their share of services provided by the administrative

Service Centers (via Allocated Costs)

maintain internal budget balance

Budgeting and control:

Page 32

a) Budget: A formal statement of the financial resources set aside for

carrying out specific activities in a given period of time. It helps to coordinate the activities of the organisation. An example would be an
advertising budget or sales force budget.
b) Budgetary control:
A control technique whereby actual results are compared with
budgets.

Prepared By: Kamlesh Damania

Any differences (variances) are made the responsibility of key

individuals who can either exercise control action or revise the original
budgets. There are a number of advantages to budgeting and
budgetary control:
Compels management to think about the future, which is probably the
most important feature of a budgetary planning and control system.
Forces management to look ahead, to set out detailed plans for
achieving the targets for each department, operation and (ideally) each
manager, to anticipate and give the organization purpose and direction.
Promotes coordination and communication.
Clearly defines areas of responsibility. Requires managers of budget
centers to be made Responsible for the achievement of budget targets
for the operations under their personal control.
A control technique whereby actual results are compared with
budgets.
Any differences (variances) are made the responsibility of key
individuals who can either exercise control action or revise the original
budgets.
Advantages to budgeting and budgetary control:
-Compels management to think about the future, which is probably the
most important feature of a budgetary planning and control system.
Forces management to look ahead, to set out detailed plans for

Page 33

achieving the targets for each department, operation and (ideally) each
manager, to anticipate and give the organization purpose and direction.
- Promotes coordination and communication. Clearly defines areas of
responsibility. Requires managers of budget centres to be made
responsible for the achievement of budget targets for the operations
under their personal control.
-Enables remedial action to be taken as variances emerge.
-Motivates employees by participating in the setting of budgets.
-Improves the allocation of scarce resources.
-Economizes management time by using the management by exception
principle.

Prepared By: Kamlesh Damania

Characteristic of good budget:

Participation: involve as many people as possible in drawing up a
budget. Comprehensiveness: embrace the whole organization.
Standards: base it on established standards of performance.
Flexibility: allow for changing circumstances.
Feedback: constantly monitor performance.
Analysis of costs and revenues: this can be done on the basis of
product lines, departments or cost centers.
In organizing and administering a budget system the following
characteristics may apply:
a) Budget centers: Units responsible for the preparation of budgets. A
budget centre may
Encompass several cost centers.

Page 34

b) Budget committee: This may consist of senior members of the

organization, e.g.
Departmental heads and executives (with the managing director as
chairman). Every part of the organization should be represented on the
committee, so there should be a representative from sales, production,
marketing and so on. Functions of the budget committee include:
Coordination of the preparation of budgets, including the issue of a
manual Issuing of timetables for preparation of budgets
Provision of information to assist budget preparations
Comparison of actual results with budget and investigation of
variances.
c) Budget Officer: Controls the budget administration. The job
involves:
liaising between the budget committee and managers responsible for
budget preparation dealing with budgetary control problems.

Prepared By: Kamlesh Damania

ensuring that deadlines are met

educating people about budgetary control.
d) Budget manual:
This document: Charts the organization, details the budget procedures
contains account codes for items of expenditure and revenue timetables
the process clearly defines the responsibility of persons involved in the
budgeting system.

Page 35

Prepared By: Kamlesh Damania

Page 36