Topic 3

Operational Budgeting and Inventory Management

Lecture Outline
1. Responsibility accounting

2. Issues of cost, revenue, profit and investment centre design

3. The nature of budgeting

4. Behavioural aspects of budgeting

5. Technical aspects of budget preparation

6. Cost Classifications

7. Inventory Management
Responsibility accounting

 An appropriate organisation structure is fundamental to achieving

organisational control.

 By establishing organisational divisions, departments, etc, we can

identify each manager’s scope of responsibility (accountability is
facilitated). See the next slide
 Organisational structure & budgeting
Organisational structure - a hotel example
(with a focus on F&B)

Hotel
General Manager

Department Department Department Department Department

Head Head Human Head Food & Head Head
Accounting & Resource Beverage Engineering Rooms
Finance Management

Manager Manager Manager Manager

Restaurant A Restaurant B Bars Banqueting
 Responsibility accounting (cont’d)
 Responsibility accounting involves holding a specific manager (or
management team) accountable for a specific element of an organisation’s
activities.

A responsibility centre and its dimensions of accountability

Inputs, (ie.
the costs of Responsibility Outputs, (eg.
resources Centre Revenue)
used)

Working capital and

fixed assets invested
Responsibility accounting (cont’d)
 There are four types of responsibility centre.
 The golden rule in responsibility accounting is that a manager should
only be held accountable for the organisational aspects that they can
affect.

Manager held only accountable for

Cost Centre
centre’s inputs (costs)

Manager held only accountable for

Revenue Centre
centre’s output (revenue)

Profit Centre Manager held accountable for costs

and revenue (i.e., profit)

Manager held accountable for costs,

Investment Centre
revenue and assets
Responsibility accounting (cont’d)
A hierarchical perspective of responsibility centre’s accountability

Investment centre
3 dimensions of accountability:
(cost and asset minimisation + revenue
maximisation)

Profit centre
2 dimensions of accountability:
(cost minimisation + revenue maximisation)

Cost centre Revenue centre

1 dimension of accountability: 1 dimension of accountability:
(cost minimisation) (revenue maximisation)
The nature of budgeting
Budget defined:

A budget is a detailed financial plan of a company’s profitability and its

raising and use of resources during a specific time period.

A Budget is an essential business management tool:

* It is a quantitative expression of a plan of action.

* It can be formulated at the organizational or any subunit level.

* It is probably the most visible way in which accounting is used in the

management control process.

* The master budget consolidates all of the subunit level budgets.

The nature of budgeting (cont’d)
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Behavioural aspects of budgeting
Traditionally, the behavioural aspects of control systems have been
afforded little attention, and accountants have been accused of
seeking technical excellence to the exclusion of concern with
behavioural implications.

There is now, however, a growing appreciation of the behavioural

implications of budgetary control. Four major budget related
behavioural issues are discussed below.
Behavioural aspects of budgeting
 a) Budgets as targets

One of the principal roles of the budget is to motivate.

Psychological research has provided strong evidence that a
quantified target increases performance.
There is wide agreement that the target should be difficult
to attain, but that the manager believes it to be
attainable.
Behavioural aspects of budgeting
 b) Budgets and performance evaluation
Budgets represent an important basis for monitoring manager
performance. Management rewards resulting from achieving budgetary
targets include salary increments and promotion. To the extent
possible, set managers equally difficult budgets, as perceived inequity
can be disruptive and adversely affect morale.

Budgets cannot always serve as a strong basis for appraising

performance, however. Before the budget is used in this manner, we
need to consider:
 Does the manager’s work lend itself to accounting measurement?
 Is there high functional interdependency?
 Is the activity in question relatively new and therefore difficult to
budget for?
Behavioural aspects of budgeting
 c) Manager participation in budget setting

Participation refers to the degree to which managers are involved in setting the
budgetary targets for which they will be held accountable for. Three benefits
derive from greater participation:
 It can result in more informed budgeting.
 It can result in managers feeling greater commitment to achieving the target
set (i.e., internalising the budget goal).
 It facilitates organisational learning as it provides managers with the
opportunity to better understand the rationale for the organisation’s direction.

A danger arises with budget participation, however, as it provides managers

with an opportunity to influence the setting of targets in a way that makes them
relatively easy to achieve, ie., “slack” budgets.
Behavioural aspects of budgeting

 d) Political aspects of budget setting

The budget is a powerful vehicle driving the reconciliation of potentially
conflicting aspirations held by managers representing the many disparate
parts of the organisation. When we recognise the degree of negotiation
and compromise needed when developing a budget, it is not surprising
that managers frequently comment on frustration experienced during
the budget setting process.
It is during the budget setting process that many managers will discover
that some of their organisational aspirations will not materialise. It is
therefore not surprising that budget setting can become highly political.
The size of a manager's budget is frequently related to the manager's
perceived organisational importance and power. Conflicting ambitions of
managers provide considerable impetus for a wide range of political
game playing during the budget-setting process.
Technical aspects of budget preparation
Just as each division’s profit and loss statement feeds into a
comprehensive profit and loss statement for a company, so the budget
comprises many schedules that feed into an overarching schedule that is
widely referred to as the master budget.

Operating budgets that feed into the master budget include:

 Sales budget
 Production budget
 Purchases budget
 Direct labour budget
 Selling expenses budget
 Administrative expenses budget
 Financial expenses budget
Cost Management Issues
Major cost classification schemes

a) Outlay vs opportunity cost

b) Direct vs indirect cost
c) Variable vs fixed cost
d) Controllable vs non-controllable costs
e) Incremental vs sunk costs
These will be discussed in the next few slides
Cost classifications
 a) Outlay versus opportunity cost

Opportunity cost is the cost of an opportunity foregone.

Imagine that we are considering extending a restaurant
on to hotel floor space that is currently leased out to a
small vendor of souvenirs for $10,000 p.a. When
appraising whether to extend, we should recognise the
$10,000 that would be lost, even though, if we do extend,
it will not be recorded as a cost in the double entry
recording system.
Cost classifications (cont’d)
 b) Direct vs Indirect costs
Direct costs are traceable to “the thing” being costed (the
cost object). In the rooms department, housekeeping
would be a direct cost of room nights sold.
Indirect costs (frequently called overheads) are not readily
traceable to the cost object. An auditor’s fee would be an
indirect cost for the rooms division.
Cost classifications (cont’d)
 b) Direct vs Indirect costs cont’d

An important aspect of the application of direct and indirect costs is

How to allocate costs to different departments in the same physical
location?
For example –
How could we allocate HR Dept. costs?
How could we allocate IT Dept. costs?
How could we allocate deprecation
costs?
Cost classifications (cont’d)
 c) Variable vs fixed costs

Variable costs vary in line with sales levels (e.g., cost of sales, sales
commissions); fixed costs do not vary with sales levels (e.g., depreciation,
rent).
This signifies that variable cost is constant per unit sold. If sales increase by 20%,
total variable cost increases by 20%.
As fixed cost is not affected by changes in the volume of sales, if sales change,
fixed cost per unit changes. For this reason, fixed cost per unit is a dangerous
number to compute. If computed, handle with care!
Costs that have a fixed and a variable component are referred to as mixed costs
(eg., sales salaries, electricity, telephone).
Cost classifications (cont’d)
 d) Controllable versus non-controllable costs

In responsibility accounting, managers should only be held accountable for costs

that they can control. If high importance is attached to accounting
measurement of a manager's performance, an attempt should be made to
segregate controllable costs from non-controllable costs.

 e) Incremental versus sunk costs

Sunk costs are costs that have been incurred in the past and are now irreversible
(ie, they represent ‘water under the bridge’).
A good example of a sunk cost is depreciation. This is because it is a cost that
relates to the purchase of an asset at an earlier time. As the fixed asset
purchase cannot be reversed, the depreciation charge cannot be avoided.
Inventory Management
 Correct levels and monitoring of inventory levels can have the
following positive results:-
• Free up funds for working capital
• Reduces the possibility of stock becoming obsolete or spoiled
• Reduces the physical requirement of storage and possible rent
lease costs
• Assists in planning the most cost effective purchase volume and
ordering pattern
Inventory Management (con’t)
 Economic Order Quantity (EOQ)
 A simple calculation
 Factors in costs of storage & ordering
 Should match normal customer demand patterns thus reduce risk
of excess stocks
 Note that as it is a calculation a business should only be guided by the
value.
 Lead Time
 The time from placing an order with a supplier to the time when it
could be expected the stock would be on site and available for
use by the business
Inventory Management (con’t)
 Safety Stock Level
 The quantity of stock on hand and available to the
business, to meet customer demand, while a stock
order is in process.
 Other considerations
 Special storage requirements (cold storage etc)
 Ifhighly mobile and valuable stock (Beverage stocks),
the need for improved security storage.
 Use by dates, (the need to keep stock at a practical
minimum).
Inventory Management (con’t)
 EOQ Formula
 EOQ = √(2 x U x O / C)
 U = usage
 O = order costs
 C = carrying costs

 See example on the next slide.

Inventory Management (con’t)
 Example:
The material DX is used uniformly throughout the year. The data about annual
requirement, ordering cost and holding cost of this material is given below:
Annual requirement: 2,400 units
Ordering cost: $10 per order
Holding cost: $0.30 per unit
Required: Determine the economic order quantity (EOQ) of material DX using
above data.
Now, go to the next slide and locate where your answer is on the table.
Notice how the costs are the least when purchased in the recommended
quantity.
Inventory Management (con’t)
 Example continued:

*Average units × Holding cost per unit: 1,200 units × 0.30 = $360
This concludes Topic 3
Attempt the questions for this week for your understanding