Understanding Business Accounting For Dummies, 2nd Edition (76 page)

Budgeting and Management Accounting

What we say earlier in the chapter can be likened to an advertisement for budgeting - emphasising the reasons for and advantages of budgeting by a business. So every business does budgeting, right? Nope. Smaller businesses generally do little or no budgeting - even many larger businesses avoid budgeting. The reasons are many, and mostly practical in nature.

Some businesses are in relatively mature stages of their life cycle or operate in an industry that is mature and stable. These companies do not have to plan for any major changes or discontinuities. Next year will be a great deal like last year. The benefits of going through a formal budgeting process do not seem worth the time and cost to them. At the other extreme, a business may be in a very uncertain environment; attempting to predict the future seems pointless. A business may lack the expertise and experience to prepare budgeted financial statements, and it may not be willing to pay the cost for an accountant or outside consultant to help.

In applying for a loan, the lender may be impressed that your business plan includes a well-thought-out budget. I (John) served on a local bank's board of directors for several years, and I reviewed many loan requests. Our bank did not expect a business to include a set of budgeted financial statements in the loan request package. Of course, we did demand to see the latest financial statements of the business. Very few of our smaller business clients prepared budgets. Although many businesses do not prepare budgets, they do establish detailed goals and performance objectives that serve as good benchmarks for management control.

Every business - whether it does budgeting or not - should design internal accounting reports that provide the information managers need to control the business. Obviously, managers should keep close tabs on what's going on throughout the business. Some years ago, in one of my classes, I (Colin) asked students for a short definition of management
control. One student answered that management control means ‘watching everything'. That's not bad.

A business may not do any budgeting, and thus it does not prepare budgeted financial statements. But its managers should receive regular profit and loss accounts, balance sheets, and cash flow statements - and these key internal financial statements should contain detailed management control information. Other specialised accounting reports may be needed as well.

Most business managers, in our experience, would tell you that the accounting reports they get are reasonably good for management
control. Their accounting reports provide the detailed information they need for keeping a close watch on the thousand and one details about the business (or their particular sphere of responsibility in the business organisation). Their main criticisms are that too much information is reported to them and all the information is flat, as if all the information is equally relevant. Managers are very busy people, and have only so much time to read the accounting reports coming to them. Managers have a valid beef on this score, we think. Ideally, significant deviations and problems should be highlighted in the accounting reports they receive - but separating the important from the not-so-important is easier said than done.

If you were to ask a cross section of business managers how useful their accounting reports are for making decisions, you would get a different answer than how good the accounting reports are for management control. Business managers make many decisions affecting profit: setting sales prices, buying products, determining wages and salaries, hiring independent contractors, and purchasing fixed assets are just a few that come to mind. Managers should carefully analyse how their actions would impact profit before reaching final decisions. Managers need internal profit and loss accounts that are good profit models - that make clear the critical variables that affect profit (see Figure 9-2 for an example). Well-designed management profit and loss accounts are absolutely essential for helping managers make good decisions.

Keep in mind that almost all business decisions involve non-financial and non-quantifiable factors that go beyond the information included in management accounting reports. For example, the accounting department of a business can calculate the cost savings of a wage cut, or the elimination of overtime hours by employees, or a change in the retirement plan for employees - and the manager would certainly look at this data. But such decisions must consider many other factors such as effects on employee morale and productivity, the possibility of the union going out on strike, legal issues, and so on. In short, accounting reports provide only part of the information needed for business decisions, though an essential part for sure.

Needless to say, the internal accounting reports to managers should be clear and straightforward. The manner of presentation and means of communication should be attention getting. A manager should not have to call the accounting department for an explanation. Designing management accounting reports is a separate topic - one beyond the limits of this book.

In the absence of budgeting by a business, the internal accounting reports to its managers become the major - often the only - regular source of financial information to them. Without budgeting, the internal accounting reports have to serve a dual function - both for control and for planning. The managers use the accounting reports to critically review what's happened (control), and use the information in the reports to make decisions for the future (planning).

Before leaving the topic, we have one final observation to share with you. Many management accounting reports that we've seen could be improved. Accounting systems, unfortunately, give so much attention to the demands of preparing external financial statements and tax returns that the needs managers have for good internal reports are too often overlooked or ignored. The accounting reports in many businesses do not speak to the managers receiving them - the reports are too voluminous and technical, and are not focused on the most urgent and important problems facing the managers. Designing good internal accounting reports for managers is a demanding task, to be sure. Every business should take a hard look at its internal management accounting reports and identify what needs to be improved.

Budgeting in Action

Suppose you're the general manager of one of a large company's several divisions. You have broad authority to run this division, as well as the responsibility for meeting the financial expectations for your division. To be more specific, your profit responsibility is to produce a satisfactory annual operating profit, or earnings before interest and tax (EBIT). (Interest and tax expenses are handled at a higher level in the organisation.)

The CEO has made clear to you that she expects your division to increase EBIT during the coming year by about 10 per cent (£256,000, to be exact). In fact, she has asked you to prepare a budgeted management profit and loss account showing your plan for increasing your division's EBIT by this target amount. She also has asked you to prepare a budgeted cash flow from profit based on your profit plan for the coming year.

Figure 10-1 presents the management profit and loss account of your division for the year just ended. The format of this accounting report follows the profit model discussed in Chapter 9, which explains profit behaviour and how to increase profit. Note that fixed operating expenses are separated from the two variable operating expenses. To simplify the discussion, we've significantly condensed your management profit and loss account. (Your actual reports would include much more detailed information about sales and expenses.) Also, we assume that you sell only one product to keep the number crunching to a minimum.

Most businesses, or the major divisions of a large business, sell a mix of several different products. General Motors, for example, sells many different makes and models of cars and commercial vehicles, to say nothing about its other products. The next time you visit your local hardware store, look at the number of products on the shelves. The assortment of products sold by a business and the quantities sold of each that make up its total sales revenue is referred to as its
sales mix
. As a general rule, certain products have higher profit margins than others. Some products may have extremely low profit margins, which are called
loss leaders
. The marketing strategy for loss leaders is to use them as magnets to get customers to buy your higher profit margin products along with their purchase of the loss leaders. Shifting the sales mix to a higher proportion of higher profit margin products has the effect of increasing the average profit margin on all products sold. (A shift to lower profit margin products would have the opposite effect, of course.) Budgeting sales revenue and expenses for the coming year must include any planned shifts in the company's sales mix.

Developing your profit strategy and budgeted profit and loss account

Being an experienced manager, you know the importance of protecting your unit contribution margins (see Chapter 9). Your division's total sales volume was 26,000 units for the year (see Figure 10-1). Your contribution margin per unit is £320 (see Figure 10-1 again). If all your costs were to remain the same next year (you wish!), you could simply sell 800 more units at a £320 contribution margin per unit to add £256,000 to your total contribution margin and EBIT (800 units × £320 per unit = £256,000). This relatively small increase in your sales volume would achieve your profit increase goal. However, costs seldom remain constant year-to-year.