The advantages and disadvantages of budget setting
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Published: Mon, 5 Dec 2016
Direct costs, indirect costs and overhead:
Direct costs: those cost that can be directly traced to producing specific goods or services. For example, the cost of leather in making bags can be attributed directly to the cost of manufacturing these products. Depreciation and administrative expenses, are more difficult to assign to specific products, and so are not considered as direct costs.
Indirect costs: those costs that not directly related to the production of a specific good or service but that is indirectly related to a variety of goods or services. Purchasing office furniture for bag manufacturing firm is one example of indirect cost because it does not affect the production of any one unit.
A cost can be direct cost of a department but it is indirect cost of the others. The classification depends on which department the cost is involved in. For example, the salary of workers working in construction site is a direct cost but the salary of managers managing this site is not direct cost, it is indirect cost.
Overheads: in business, overhead expense refers to an ongoing expense of operating a business. All costs on the income statement are regarded as overhead expense except direct materials and direct labor expense. For instance, depreciation expense, advertising, insurance, rental fees, telephone bills, repairs, office supplies and utilities costs are overheads.
c. Controllable and uncontrollable costs:
– Controllable costs: costs that can be influenced by the department involved or managers are capable of controlling them.
– Uncontrollable costs: costs that managers cannot influence significantly or managers cannot control them.
2. Evaluate the statement of the delegate
In my point of view, the delegate misconceived the terms used in the statement, so for this reason I strongly disagree with this statement.
Costs are assigned to cost objects for a variety of purpose including pricing, profitability studies and control of spending. Based on the purpose of management, the costs are classified as the following:
For cost volume profit analysis or profitability studies, costs are divided into three categories fixed cost, variable cost and semi-variable cost.
For pricing, costs are classified into direct costs and indirect costs.
For control of spending, costs are divided into controllable costs and uncontrollable costs.
Because of the misconception about classification of cost, the delegate used the terms in this statement wrongly.
Direct costs can be regarded as both fixed costs and variable costs.
As I have mentioned through the obvious example above, direct costs like the salary of workers working in construction site is a fixed cost. Every month, the company has to pay the fixed rate salary for the workers according to the colored labor contracts they have made. On the other hand, most of variable costs such as direct input materials, direct labor per unit are direct costs.
Indirect costs can be either fixed costs or variable costs.
In contrast with direct costs, most of indirect costs are fixed costs, for example the rental fees for representative offices, sale department and the security cost. These costs do not directly attribute to manufacturing products thus they are indirect and fixed costs. On the other hand, labor costs can be indirect as in case of maintenance personnel or executive officers.
Controllable and uncontrollable costs:
For control of spending purpose I have mentioned above, costs are classified into controllable and uncontrollable costs that represent the level of management in a term.
When you have authority to select the input materials, the methods and staffs, the collection can be regarded as controllable costs. If you made a multi-year agreement to contract for collection at fixed year fees, the cost can be uncontrollable. In lower management levels, the manager does not have enough leading skills so with any type of costs the manager can not control which becomes uncontrollable cost. In contrary, in the higher management level, both fixed costs and variable costs can be under controlled.
1. Participation in budget setting
Participative budgeting is the situation in which budget are designed and set after input from subordinate managers, instead of merely being imposed. The purpose of participation in budget setting is to divide responsibility to subordinate managers and set a form of personal ownership on the final budget. The budgeting approach in which the subordinate participates in budget setting, they provide their own information that the supervisors use to formulate the self – imposed budget or participative budget (Chapman, Hopwood & Shields, 2006). Organization performance is expected to be well improved by making it possible for the supervisor to allocate the resources more efficiently. According to the information provided by the subordinate, the right resources-allocation decisions are making, the participative budgeting will improve the organization performance.
Participation in budget setting has its desirable effects on an organization performance these include the transference of information from subordinate to superior so that it can increase subordinate’s job satisfaction. In addition, its advantages contain budgetary responsibility and higher motivation to achieve the goals. Besides the desirable effects, participative budgeting has its undesirable effects these include time consuming, padding the budget. However, the condition which determines the success of a participative budget depends on various factors such as job related information, the level of participation, the level of subordinate influence and complexity of budget.
Transferring information from subordinate to superior is one of the participative budget setting advantages. Subordinates have opportunities to contact directly to the superior and discuss organizational issues with the superior so that they can exchange the information and ideas can solve the problems and unite future point of views. The transferal of information is particularly important when high difficult task is being deal with, the more difficult the task is, the greater the need for subordinate’s consultation. In addition, when people participate in setting a budget, they are recognized as members of a team, they share budgetary responsibility and motivation is higher when they together accomplish their own goals rather than the goals are imposed.
Besides the desirable effects, participative budgeting has its undesirable effects for an organization. Time consuming is the biggest disadvantage of participation in budget setting. Vacillation and delay can be made when too many meetings are hold. Budgetary slack is another undesirable effect, happens because of overestimation of expense that can foster budgetary “gaming” through budgetary slack. Unless incentives to accurate projects are provided, padding the budget can be severe.
A variance is the difference between planned, budget or standard cost and actual cost, and similarly for revenue. The total budget is the difference between the actual cost of the input and its planned cost.
Total variance = (AP x AQ) – (SP x SQ)
Where AP is the actual price per unit of the input
AQ is the actual quantity of input used
SP is the standard unit price
SQ is the standard quantity
Price variance is the difference between the actual and standard unit price of an input multiplied by the number of inputs used (AP – SP) x AQ.
Usage variance is the difference between the actual and standard quantity of inputs multiplied by the standard unit price of the input (AQ – SQ) x SP
Total variance = Price variance + Usage variance
= (AP – SP) x AQ + (AQ – SQ) x SP
= (AP x AQ) – (SP x SQ)
When actual prices or usage of inputs are higher than standard prices or usage, unfavorable variance will occur. When opposite occurs, it will lead to favorable variance. Variance always exists unless the project plan is perfectly executed. Both unfavorable and favorable variances are not equivalent to good and bad variances. Normally, whether variances are good or bad depends on why they occurred. Significant variances inform management that something needs to be examined.
In fact, it is rare when manufacturing performance is exactly the same as the established standards and it will not be expected. Random variation around the standard are expected. In order to deal with a deviation between plan and actual, for each company, the managers should establish an acceptable range of performance. The acceptable range is the standards of allowable deviation. When a variance occurs, if it is in this range, it is assumed to be caused by random factors. If a variance occurs outside this range, the deviation is likely to be caused by non-random factors. Non-random factors include both of controllable and uncontrollable cases. In the non-controllable case, managers need to revise the standards. Based on experiences from past, intuition and judgment, managers determine the allowable deviation from standards.
1. Explaining the terms used
a. Committed fixed costs
Fixed costs are costs that remain constant, in total, regardless of changes in the level of activities. Despite the activity levels increase or decrease, the fixed costs are still the same, in total, if other outside factors like price changes do not occur. However, fixed costs will be changed on per unit basis. Fixed costs can be viewed as being committed for prior decision or contract. In the other words committed fixed costs are costs that relate to the investment in facilities, equipment as well as depreciation and the basic organizational structure of a firm. In addition, contract for recruiting employees such as the salaries of managers and supervisors are also committed fixed costs.
b. Uneven revenue flows
Uneven revenue flows indicate the situation that a company has to deal with when customers show their high or low demand for products or services which the company provides. Actually, uneven revenue flows can be predictable and depend on the period of time in a year. Travel companies and hotels are typical of uneven revenue flows because tourists are merely occasional customers. It is obvious that in the summer a travel company has the biggest number of customers than other reasons. Also, a swim suit shop has high level of demand in the summer and there is hardly demand in the winter or spring.
2. Implication of the above situation for the company
An executive has asserted that many costs of their costs are committed fixed costs then it is likely to have a high break – even point. It means that before getting profits, the company has to operate at high level but when it pass the break – even point its profit will raise rapidly because of the increase in revenue leading to a high P/V ratio.
There are 2 ways to raise profit, one is increase revenue and another one is decrease costs. In short period of time, profit will not be much influenced by these committed fixed costs. Therefore, in stead of adjusting the costs, the executive should forward to revenue side of business. Profit will be maintained at reasonable level if the revenue is achieved above the break-even level.
Focusing on gaining revenue, particularly during the periods of low level of demand, the company should capitalize all the opportunities. Taking a flexible approach, the company offers the price of the products or services to suit the situation of the company and the price the customers agree or willing to pay. When the company operates below the break – even level, it can accept any price higher than variable cost.
Unlike manufacturing industry, leisure or tourism industry products can not be stored. Normally, in manufacturing industry in low level of demand time, they can manufacture products for stock and does not need to be flexible. For example, a textile winter company whose main products are pullovers, woolen scarves, gloves etc. Actually, these products are provided to consumers in winter, summer is the low demanded season. Therefore, in summer the company does not concentrate on sale strategy but manufacturing strategy to produce more products satisfying winter demand.
A flexible approach to pricing means executing a pricing strategy in order to attract as much customers as possible when the market demand for products or services that the company provides is low. The price will increase in high-season or busy period. In this time, the company expects to operate with full capacity. For example, in summer, people often go for traveling, demand for booking rooms increase, therefore the hotel room prices are usually higher. Hotels have to operate their full capacities to server tourists and visitors. Whereas in winter or spring when the number of tourists and visitors is significantly decrease, hotels will offer the new lower price or provide full package holiday with the promotion.
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