Session 12

Budgeting—Nature, Purpose
and Behavioural Aspects

FOCUS
This session covers the following content from the ACCA Study Guide.

C. Budgeting
1. Nature and purpose of budgeting
a) Explain why organisations use budgeting.
b) Describe the planning and control cycle in an organisation.
c) Explain the administrative procedures used in the budgeting process.
d) Describe the stages in the budgeting process (including sources of relevant
data, planning and agreeing draft budgets and purpose of forecasts and
how they link to budgeting).
7. Behavioural aspects of budgeting
a) Explain the importance of motivation in performance management.
b) Identify factors in a budgetary planning and control system which influence
motivation.
c) Explain the impact of targets upon motivation.
d) Discuss managerial incentive schemes.
e) Discuss the advantages and disadvantages of a participative approach to
budgeting.
f) Explain top down, bottom up approaches to budgeting.

Session 12 Guidance
Memorise the acronym "CRUMPET", which can be used to understand the objectives of budgeting
(s.1.2).
Note that the budgeting process, as described in section 2.1, is useful in preparing key and functional
budgets (Session 14).

(continued on next page)

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VISUAL OVERVIEW
Objective: To explain the budgeting process and the behavioural aspect of budgeting.

ROLE OF BUDGETS
• Objectives of Budgeting
• Planning and Control Cycle

BUDGETING PROCESS BEHAVIOURAL ASPECTS OF

BUDGETING
• Stages
• Importance of Motivation
• Administrative Procedures
• Factors Influencing
• Sources of Relevant Data
Motivation
• Planning
• Management Styles
• Agreeing Draft Budgets
• Targets and Motivation
• Purpose of Forecasts
• Managerial Incentive
Schemes
• Budgeting Approaches
• Theories of Human Behaviour

Session 12 Guidance
Learn the behavioural aspects of budgeting (s.3), which address issues of motivation, classifying
employees based on work attitudes, management styles, types of targets and whether the budget
should be prepared using a top-down or bottom-up approach.

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Session 12 • Budgeting—Nature, Purpose and Behavioural Aspects F2 Management Accounting

1 Role of Budgets

*Although budgets are

generally considered
in monetary terms,
Budget—a quantitative statement, for a specified period of time, not all budgets
which may include planned income and expenditure, assets, liabilities are monetary. For
and cash flows. example, a production
budget is generally
 Typically, budgets are prepared for a reporting period broken quantified in units.
down into monthly, or even weekly, periods.*

1.1 Objectives of Budgeting

Coordination Budgeting brings together the many different

activities in the organisation, which helps achieve
"goal congruence". This is particularly important in Memorise the
decentralised organisations. acronym CRUMPET
to help remember
Responsibility Assigning responsibilities to an individual for costs,
profit, revenues, investment, etc which helps
budgeting objectives.

facilitate management "by exception".

Utilisation Having a budget should ensure that resources are

not acquired in excess of needs and that best use
is made of scarce resources.

Motivation Research shows that targets motivate individuals to

achieve the budget (which links to responsibility),
as compared to having no target.

Planning and A budget is shorter-term version of a longer-term

plan.
control
Actions in the short term should be consistent with
the long-term goals to be achieved.
The comparison of actual outcomes against
budget provides a means of control (e.g. through
"variance analysis").

Evaluation A budget may provide a "target" for the

performance evaluation of individuals and/or
departments.

Telling Superiors should communicate their plans to help

achieve goal congruence (i.e. managers should
lead their staff members to take actions which
are in their own self-interest and the entity's best
interest).

1.2 Planning and Control Cycle

Planning involves:
 Systematically establishing objectives.
 Formulating, evaluating and selecting policies and courses of
action to achieve objectives.
 Planning can be short term (operational) or long term
(strategic).
Short-Term/Operational Planning Long-Term/Strategic Planning
 For periods ≤ one year.  For periods > one year.
 Also called budgeting.  Also called corporate planning.
 Accepts current operating environment
and resources.

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F2 Management Accounting Session 12 • Budgeting—Nature, Purpose and Behavioural Aspects

Control is concerned with:

 The process of ensuring that activities conform to plan and
that objectives are achieved.
 The measuring of actual performance against budget.
*There is a cycle,
The planning and control cycle incorporates planning and because if there
control and involves seven steps:* are differences the
response should be
1. Identify objectives. to return to the most
2. Identify alternative courses of action (strategies). suitable step.

3. Gather data about alternatives. For example, re-plan

(step 2), select an
4. Select course of action. alternative course
of action (step 4)
5. Implement the long-term plan as the annual budget.
or revise the annual
6. Monitor actual results. budget (step 5).
7. Respond to differences between the actual and the plan. *The terms "principal
budget factor",
"key budget" and

2 Budgeting Process "functional budgets"

and the preparation of
budgets are explained
in Session 14.
2.1 Stages*

Identify the Prepare the Budget officer Budgets

objectives of key budget produces communicated
the business master to centre
budget managers
including responsible for
income implementation
statement
Prepare the and
Clarify the statement
functional
organisational of financial
budgets
structure of position Actual results
the business measured,
compared
with budget
and analysis
Budget undertaken
submitted
Identify the to budget Budgets
principal committee approved by
budget factor for approval the board Action taken

2.2 Administrative Procedures

The budget committee is made up of key senior management
personnel (e.g. directors and divisional executives) who are
responsible for:
 overall policy matters relating to the budgeting process; and
 coordinating the preparation of the budget.

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Session 12 • Budgeting—Nature, Purpose and Behavioural Aspects F2 Management Accounting

The committee:
 resolves issues (particularly disputes) which arise in the
setting of budgets;
 approves the final budget; and
 receives periodic reports comparing actual progress with
budgeted goals.*
Although the committee is responsible, it is the budget officer who
manages the entire budgeting process. In larger organisations,
*Operating statements
the budget officer will issue a budget manual which details how the (see Session 16) are
budgets of every division are to be developed. This ensures that an example of such a
the budgets are drawn up using consistent assumptions and bases. report.
Key assumptions may include, for example:
 price inflation and pay-related cost increases;
 estimates of demand changes; and
 tax, interest and foreign exchange rates.

2.3 Sources of Relevant Data

Data and information come from multiples sources—both internal
(inside the business) and external. Businesses need to capture
and use information which is relevant and reliable.

2.3.1 Internal Data

Accounting records are a primary source of internal data. These
records detail past transactions which may be used as the basis
for planning for the future (e.g. preparing a financial budget or
forecast). They are primarily used to record what has happened
to the financial resources of a business. For example, how cash
has been obtained and spent; what assets have been acquired;
what profits or losses have been made on business activities.
Accounting records also provide non-financial information. For
example, documented reasons for raising debit notes to suppliers
or credit notes to customers can provide useful information about
the quality of materials purchased/finished goods sold. Data
analysed from sales invoices provide a profile of which products,
to whom and in which markets sales are being made.
Much internal information is related to the accounting system—
but not a direct part of it. For example:
 employee records (personal details; wage rates or salary;
skills and experience; training records);
 costings for tenders for contracts;
 production department data (e.g. number of machines;
operating capacity; repairs and maintenance records); and
 records of direct contact with customers (e.g. complaint
letters, calls received by a customer service centre).
Not all internal information is provided formally. For example,
relevant and reliable information may be communicated through
regular meetings of staff and management without formal
documentation.

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F2 Management Accounting Session 12 • Budgeting—Nature, Purpose and Behavioural Aspects

2.3.2 External Information

One category of external information concerns ways in which
business activities need to be undertaken. For example:
 Businesses must keep records in order to collect taxes on
behalf of the government and so need regular and up-to-date
information about the taxation system (e.g. VAT, corporate
profits tax) and what actions need to be taken (e.g. returns
submitted, payments made).
 Businesses need to be aware of laws which affect their
activities (e.g. environmental legislation, health and safety
regulations, labour law).
A second category of internal information is "market" or
"competitive intelligence" (i.e. information about the market or
markets in which a business operates). This may be obtained
through market research.

2.4 Planning
Planning is crucial to the budgeting process.* *"If you don't know
where you're going,
 Planning should precede and inform the budgeting process. you might wind up
The planning process should be open to continual change and someplace else."
improvement. —Yogi Berra
 Both the planning and budgeting processes should be as
transparent and participative as possible because information
is most effective when it is shared.
 Items in a budget are connected to measurable outcomes.
Assessment of those outcomes provides information for future
plans.

2.5 Agreeing Draft Budgets

Proper financial management and planning should extend beyond
the next financial year. Agreeing draft budgets for the medium-
term (e.g. the next two to three years) is considered good
management.*
*Agreeing draft
Draft budgets: budgets is particularly
 are important in developing a robust strategy which does not relevant in the not-
focus solely on the short-term; for-profit sector
(e.g. government
 present a realistic starting point for ongoing refinement; and departments) where
 provide future projections that may show where future budgets have to be
efficiencies will have to be made. "balanced" with the
levels of funding which
2.6 Purpose of Forecasts are expected to be
available.
Forecasts and projections are a major activity in the planning
processing. Forecasting involves the analysis of past data
and present conditions for the main purpose of estimating the
occurrence, timing and/or amount of future events.

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Session 12 • Budgeting—Nature, Purpose and Behavioural Aspects F2 Management Accounting

Illustration 1 Forecasting

An increasing trend over 10 years in demand for an IFRS publication

may provide a basis of forecasting the demand for an update of that
publication next year. Activities can then be planned to meet that
demand. Resources needed to carry out those activities can then be
budgeted.

The process of forecasting:

 helps to identify the key drivers of relationships between budget
items and to formulate assumptions which can be made;
 provides estimates (e.g. of demand) to form the basis of the
planning process; and
 informs decision-makers to help shape outcomes.*

*A forecast does not predict the future. However, by understanding

how, for example, demand changes in response to particular events
(e.g. an increase in sales tax), management can plan how to react to
such a change should it arise.

3 Behavioural Aspects Of Budgeting

3.1 Importance of Motivation in Performance

Management
Motivation is generated by the interaction of conscious and
unconscious factors such as: Motivation—the
internal and external
 intensity of desire or need; factors which
 incentive or reward value of the goal; and incentivise and
energise people to be
 expectations of the individual and others. continually interested
Individuals are principally motivated by their own interests. in and committed
Motivation in performance management is therefore important to to a job or role and
align personal interests with organisational objectives. to strive towards
attaining a goal.
3.2 Factors Influencing Motivation
In many organisations, managers are at least partly evaluated
on how they perform in relation to the budget which was set.
Therefore, the budget is likely to influence the behaviour of those
managers and should motivate them to achieve higher levels of
performance. Several factors will influence this:
 management style;
 the level at which targets are set;
 reward systems;
 approaches to budgeting ("top down" or "bottom up"); and
 degree of participation.

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F2 Management Accounting Session 12 • Budgeting—Nature, Purpose and Behavioural Aspects

3.3 Management Styles

One of the first management writers to consider the effect of
budgets on behaviour was A. G. Hopwood, who carried out
a survey of budgeting practices during the 1970s to identify
how budgets influenced the behaviour of managers. Hopwood
identified three management styles:
1. Budget-constrained: Managers are evaluated on their ability
to meet budgets in the short term. Failure to meet budgets
results in poor evaluations, regardless of the reasons.
2. Profit-conscious: Managers are judged more on their ability
to contribute to long-term success rather than merely meeting
the budget. Budgets are used but are applied more flexibly.
If the budget was not achieved, but for a good reason, the
manager would not be penalised.
3. Non-accounting: Accounting data is not considered important
for performance evaluation. Qualitative factors are seen as
more important (e.g. customer satisfaction).
The following table summarises the effect of the three styles on
the behaviour of managers:

Style
Budget- Profit- Non-
Features constrained conscious accounting

Involvement High High Low

with costs

Job-related
High Medium Medium
tension

Manipulation
Extensive Little Little
of data

Relationships
with Poor Good Good
superiors and
colleagues

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Session 12 • Budgeting—Nature, Purpose and Behavioural Aspects F2 Management Accounting

3.4 Targets and Motivation

Research has shown that:
 Targets can be used to motivate employees.
 If targets are too easy to achieve, individuals will not be
motivated to improve performance.
 Also, if targets are too difficult, then they will results in
demotivation.
*This is only a general
 Targets which are just out of reach are optimal for rule, as the optimal
motivation.* target may differ
 If individuals have higher levels of intended achievement, then between individuals.
actual achievement rises.

Performance level Optimal budget

Budget

Zero variance
Adverse variance

Actual performance

Easy Hard

Degree of budget difficulty

*An unfavourable difference between actual and budgeted

performance (an "adverse variance") arises because the optimal
performance is achieved by making the target just unattainable. As a
manager or budget holder is likely to react adversely to this, a slightly
lower standard might be set for performance-evaluation purposes.

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F2 Management Accounting Session 12 • Budgeting—Nature, Purpose and Behavioural Aspects

3.5 Managerial Incentive Schemes

3.5.1 Objective
The primary objective of a managerial incentive or reward
Incentive/reward—
scheme is to motivate managers to achieve the company's all of the monetary,
objectives. A good scheme should: non-monetary
 have a positive effect on recruitment and selection policy; and psychological
payments which an
 be affordable; and
organisation provides
 be fair (i.e. objective and unbiased) and consistently applied. for its employees in
Rewards may be extrinsic or intrinsic: exchange for the work
they perform.
 Extrinsic rewards are tangible (e.g. salaries, bonuses and
benefits).
 Intrinsic rewards refer to intangible aspects (e.g. self-esteem).
3.5.2 Types of Incentive Schemes
The various types of incentive schemes include:
 Individual bonuses (usually in the form of cash) based on
the achievement of targets.
 Performance improvement schemes under which
participants are typically rewarded with non-cash bonuses.
Higher targets are set each year to ensure continuous
improvement.*
 Under profit-related pay schemes, bonuses are based on
*Non-cash bonuses
the level of profitability of the organisation as a whole.
make such schemes
 Share option schemes are usually associated with senior more flexible.
executives being given the option to buy company shares Additional bonuses can
at some future date for an agreed price. If the share price be paid (if appropriate)
increases, an executive will profit by buying the shares at the without needing to
option price and selling them at the higher price. consider parity of pay
or potential issues with
 Group bonus schemes may offer financial or non-financial
unions.
rewards to a group of managers and employees if the group
achieves specified targets.

3.6 Budgeting Approaches

Top-down budgeting: Budgets are prepared by senior
management. In practice this is usually done through the finance
department.
Bottom-up budgeting: Managers participate in the preparation
of their department's budget. This usually means that they
prepare the budgets for the department they are responsible for.
These budgets are then approved by senior management (usually
after some negotiation and discussion).

3.7 Theories of Human Behaviour

Douglas McGregor developed two theories of human behaviour
at work according to people's nature and talents: Theory X and
Theory Y.
3.7.1 Theory X 3.7.2 Theory Y
This theory assumes that people: This theory assumes that people:
 dislike work;  seek responsibility; and
 dislike responsibility;  want to participate in decision-
 are only motivated by money; and making.
 must be told what to do.

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Session 12 • Budgeting—Nature, Purpose and Behavioural Aspects F2 Management Accounting

Employee Type* X Y

Motivated by Money Many factors

Does participation No Yes

increase motivation?

Management style Authoritarian Participative

approach approach

Budgeting style TOP DOWN BOTTOM UP

*Some organisations employ "theory X-style" managers, and

others employ "theory Y-style" managers. The type of manager(s)
determines which method of budgetary control is the more
appropriate for a particular organisation.

3.7.4 Advantages of Participative Approach

Budget holders are more likely to accept and be committed to working
towards targets which they have been involved in designing.
Budget holders will be more motivated and have higher morale if they are
given more autonomy.
Budgets are more likely to be realistic, as they will be based on information
from the managers who are most familiar with the areas concerned.

3.7.5 Disadvantages of Participative Approach

Managers may try to set targets which are too easy by incorporating "slack"
(padding) into their budgets. Budgetary slack means adding expenses to
the budget in excess of what is expected to be needed (or understating
target revenues).
Setting the targets is likely to be more time consuming, which slows down
the budget preparation process.
Setting of targets may not be fair as some budget holders will be better
negotiators than others (e.g. in setting themselves more achievable targets).
Senior management may lose some control of the business as a result of
delegating decision-making to local managers.
Less experienced management may make decisions which are not in line
with the company's strategic plan.
Depending on the relative abilities and experience of senior and junior
managers, participation could be argued to produce poor-quality decisions.

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 Session 12

Summary
 A budget is a quantitative or financial plan for a specified future period. It includes
planned revenues and costs, and may include planned assets and cash flows.
 The main objectives of budgeting can be remembered using CRUMPET.
 The budget committee and the budget officer have specific roles and responsibilities in the
budget process.
 Sources of data for budgeting purposes may be internal or external.
 Planning, control and forecasting are all linked to the budgeting process.
 Budgets influence the behaviour of managers, because the evaluation of their performance
usually depends on whether they achieve the budget.
 Reward systems are one of many factors which influence motivation.
 Management incentive schemes may include cash bonuses, non-cash rewards, share
options and so forth.
 The difficulty of a budget should be challenging, but not unachievable, or it will
demotivate.

Session 12 Quiz
Estimated time: 15 minutes

1. State the objectives of budgeting. (1.1)

2. List the steps involved in the planning and control cycle. (1.2)

3. List TWO responsibilities of the budget committee. (2.2)

4. Describe the primary source of internal data. (2.3.1)

5. True or false? In a profit-conscious style of management, managers are evaluated on their

ability to meet budgets in the short term. (3.3)

6. What degree of target will best motivate people? (3.4)

7. Describe TWO types of incentive schemes. (3.5.2)

8. State how the "top-down" and "bottom-up" approaches to budgeting are related to McGregor's
theories. (3.7)

Study Question Bank

Estimated time: 35 minutes

Priority Estimated Time Completed

Q47 Setting budgets 20 minutes

Q48 Behavioural arguments 15 minutes

Additional
Q46 Planning and control cycle

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