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CHAPTER 7: BUDGET FOR THE SHORT TERM

Management by objectives works if you first think through your objectives. Ninety percent of the time you haven’t.

Peter Drucker

The conventional definition of management is getting work done though people, but real management is developing people through work.

Agha Hasan Abedi

Managers can plan. They can dream dreams of the future for their firms. However, for their plans or dreams to connect to reality, for them to be implemented, for them to lead to actions that will actually help achieve their plans other people besides managers are going to have to do something. And it will not just be any old something, any sort of actions. It will need to be actions consistent with the plans or dreams of the managers of a firm. Actions that will significantly and directly help achieve the plans of managers.

So managers not only need to plan and dream dreams. They need to communicate their plans, objectives and dreams to others in their firm. They need to bring others along with them, to lead them, to have others want to contribute to their plans, to be part of the bigger vision. Managers can do this through personal contact with others: through words, through genuine personal interest and care for others, through communicating a laser-like focus on an objective, through demonstrating determination and perseverance, and through a clearly seen personal commitment to the value of the task ahead. There also needs to be precision in the communication from managers about what they expect from others, if managers are to direct the future actions of others.

While flying across the Tasman Sea between Australia and New Zealand it occurred to me I had probably been walking the distance between Sydney in Australia and Wellington in New Zealand each year for the previous few years. It is a bit over 2,000 km between Sydney and Wellington. I used to have a house in Karori, a suburb in Wellington perched about 250 metres above sea level. For a number of years, most working days I walked between Karori and Wellington’s CBD, which is nestled at sea level on one of the world’s great harbours. It is a 4 to 5 km walk each way; so the return trip is about 9 km.

If I did this 5 times a week, I would walk about 45 km a week; and over, say, 45 weeks a year it would be about 2,000 km a year. This would be roughly the distance between Sydney and Wellington. In more recent times I have instead been walking along the beach from my apartment in Yeppoon, Queensland about 3 km north and back again early each morning. That is a trip of about 6 km each day. If I do this every day of the week, I am walking over 40 km a week. In a year I would walk much the same distance as I used to in New Zealand.

So the 2,000 km walks I had been doing each year in Wellington, and now more recently do in Yeppoon, sound like very long walks. But they start with just one step as I close the front door and step down from my home each day. Just one small step... I could never walk 2,000 km or more each year, which would be 20,000 km or more each decade, unless I took that first step out of my front door. My first step... A lot does not happen in our world because we do not take the first step on a long journey. Managers need to support people to take their first step (and the second and subsequent steps) that will collectively take the firm in the desired direction, that will cause the dreams flowering in the minds of managers to gradually struggle into reality and see the light of day.

This chapter is about how accounting can help or hinder managers to communicate clearly their plans to others in a firm and to facilitate them collectively and in a co-ordinated way to do things that will help achieve managers’ plans in the short-term. In this chapter we are looking at the ‘first steps’ in what can often be very long journeys for firms. Not necessarily the ‘first steps’ in the sense of a new firm being started up and lurching

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forward in the first steps of its new corporate life. Rather, it is the ‘first steps’ in the sense of the next steps, the short-term, taking the ‘first steps’ from where we are currently to help us move forward in the short-term in the right direction to where we want to be going as a firm. In this chapter we will be looking at how budgets can help managers communicate their plans to others and ensure that the resources of a firm are used in the short-term in a way that is consistent with the overall objectives of a firm.

If we do not take the next steps in the direction we want to be going, we will never get to where we want to go. The question to ask ourselves in this chapter is can accounting really help, or is it more likely to hinder, managers to communicate their plans and ensure the resources of their firms are used in the short-term in a way that is consistent with their plans? This is because managers need to get work done through people. But, of course, people are the end, not the work. Firms operate for people, for all those with a genuine interest in what a firm does. As far as a firm’s staff is concerned, management is about developing people through work. This is the way to get the work done and to achieve managers’ dreams for a firm. In this chapter let us consider whether accounting can really help managers ensure others take these all important ‘first steps’ in a business?

7.1 Reasons for budgeting

A budget is just a method of worrying before you spend money, as well as afterward.

Anon

The reason for budgeting is to ensure the detailed short-term implementation of managers’ plans actually takes place. Or is it? In practice, budgets are usually for a one year period, broken down into monthly (and sometimes weekly or daily) budgets. They focus on the next steps, the ‘first steps’ in the rest of the journey of a firm. Budgets can potentially have a number of advantages for a firm. These can include encouraging short-term planning, encouraging co-ordination and co-operation within a firm, communicating clearly and precisely managers’ plans, delegating responsibility and accountability to others and motivating staff. Indeed, it is little surprise that for almost all businesses budgeting is an integral part of their management accounts. But does budgeting really do these things? A question we will ask ourselves in this section is: how could it?

Short-term planning

Budgets can provide a discipline to managers at different levels in a firm to focus on setting short-term targets consistent with the overall objectives of a firm. This can help everyone foresee potential future issues in the short-term before they happen, before everyone is embroiled in ‘fighting fires’ or in an emergency. For example, budgeting or planning cash levels in a firm can help managers foresee potential cash shortages in the future before they happen. This gives a firm the opportunity to fix a problem before it actually becomes a problem. In budgets, words can be used as well as numbers; but mostly they are made up of numbers. Most of the numbers have dollar signs in front of them. And the numbers are the plan and the dreams and the ideas. They are specific and precise. Everything seems to come down to the dollars. At least life starts to seem simpler. Or does it? Or could it?

Co-ordinate

As well as providing discipline for short-term planning, budgets can also provide a vehicle for different parts of a firm to ‘talk to each other’ and to co-ordinate aspects of their activities so they are more in line with the overall objectives of a firm. Budgets can add a crispness and clarity to these communications. Crisp salads are good and so are crisp communications. Everyone knows where they stand and where they sit. The budgets can make it very clear what is expected of different parts in an organisation and how those parts are going to need to talk to each other and work together. Yes, work together. With or without budgets, why can that be such a difficult thing for people to do in firms?

Communicate

Budgets can also provide a vehicle for managers to clearly and precisely communicate their objectives and strategies and what they mean for the short-term or immediate actions of groups and individuals in a firm. It is

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all very well to have a road map for the future into the years ahead for a firm, but to get there the ‘first steps’ need to be taken by other people. Budgets can help make clear to others throughout a firm what those ‘first steps’ are or might be. Individuals, a whole lot of individuals, need to know what is expected of them, what their part is in the journey the firm wants to go on. People need to know whether they even have a part to play, a part that might count for something in the bigger plan. If the messages are made clear it is certainly a start. It is a very important start; indeed, a key start to a firm taking the ‘first steps’ in going forward.

Delegate

Having said this, it is not possible nor desirable for managers of a firm to plan in detail what every individual in a firm needs to do moment-by-moment in their job, to communicate this to every individual and then to ‘check up’ on everyone to make sure they are doing everything—every detail—exactly as managers want them to do it. It is not possible, because to do so would require managers to not only have ‘eyes in the back of their heads’ but to have a lot of eyes. Indeed, each human being, regardless of whether they are a manager of a firm or not, only has two eyes. That is right; just the two. So we are limited.

Also, even if it was possible it would not be desirable for managers to plan every detail. It would not be desirable because managers do not know everything. In fact, some people in firms think managers do not know anything. As firms get larger, as their scope and reach and influence gets larger, managers need to delegate more and more decision-making to others. This means people will have considerable scope to act within the often broad boundaries of the overall objectives and goals of a firm. So we have to trust people. Well, at least within reason we do; within clear guidelines, boundaries and parameters.

We like to place some limits around our trust of others, particularly when we are giving them other people’s money (to say nothing about our dreams as managers) to play around with. There have to be some limits in order to reduce our potential disappointments. Otherwise we might become too disappointed and give up our dreams and plans and imagined futures (or, indeed, lose our jobs as managers). Our dreams (and careers) are too valuable to be handed over willy-nilly to others. No, we want to delegate clearly and with precise boundaries our trust to others. Budgets, because they are in numbers, can help us do this.

Motivate

Also, we all need to get up in the morning. We have to leave our soft, warm bed and roll out of the sheets and head into the shower. We have to get out of the front door of our home and head ‘into work’. And stay there all day. Each day it comes down to whether we want to be there or not. Whether we want to be somewhere else; whether we believe in what we are doing, or not. Budgets can help motivate us in the short-term; make it clear what we have to do. Motivation is having the motive force to do something, the internal motor that pushes us forward to the goal. We need that each day, indeed each step of the way as we fulfil the requirements of a firm’s short-term plans. Budgets can do this for people in a firm; they can do this for you and me ... maybe.

These are all potential benefits of budgeting. To co-ordinate, communicate, delegate and motivate. A lot of words ending in ‘ate’. All these words also involve people. They involve the effect of words and numbers on real people who are usually just trying to live their lives. Most firms budget. Indeed, as you enter the ‘management ranks’ in a firm one of the first things you will be confronted with is being responsible for a budget for your team or group within a firm. All the potential advantages of using budgets for a firm revolve around people in a firm. Budgets can encourage people to plan in the short-term, encourage people to ‘talk to each other’ and to co-ordinate their activities across a firm and encourage detailed communication from managers to people of what is expected of them in the short-term. Budgets can help delegate responsibility to people within a firm and help motivate them to act in ways consistent with managers’ plans and objectives. And, of course, managers are people too. Everything seems to involve end-to-end people and that is where budgeting can come unstuck.

So the benefits of budgeting, the reasons why so many firms do it, revolve around the potentially favourable impacts of budgeting on people. These favourable impacts involve helping managers ensure other people in a

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firm act on a day-to-day basis in a way consistent with managers’ vision, dreams, plans and objectives for a firm. Can budgets really do this? One thing we know about people (being, of course, human beings ourselves) is that we are all thinking, living people with our own dreams, desires and aims. We are people, not machines. We have our own intentions and plans. These may, or may not, line up particularly well with those of the firm we may at present work for. Yet for managers to achieve their plans, aims and objectives for a firm other people need to act in ways consistent with them. How can budgets help managers and other people do this? Indeed, can they?

We are sitting in the United Airlines Red Carpet Lounge in Terminal 3 at Heathrow Airport in London waiting for a plane. Sipping a light beer and looking out the window we see a Singapore Airlines plane arrive at Gate 8 nearby. Various people come scurrying out to service the plane, including a group of baggage handlers. We see one baggage handler grab the first bag off the plane and run off with it and disappear into the terminal building. At first we think the person has, for some inexplicable reason, brazenly stolen the bag and disappeared. We have another sip on our beer and wonder whether perhaps we should ‘report’ to someone what we have just seen.

Inside the terminal the person has loaded the bag onto the conveyor belt that takes it onto the baggage carousel. This lonely bag arrives on the baggage carousel and starts circling round and round before its owner has even stepped out of the plane’s door and onto the air bridge. The bag continues its lonely vigil while its owner proceeds through customs and heads to the baggage carousel. The bag then greets its surprised owner who promptly grabs it, puts it on their trolley and waits patiently for their second bag. After quite a long wait, eventually the rest of the bags appear on the baggage carousel.

Sipping our beers in the United Airlines Red Carpet Lounge we do not see what happens inside the terminal but we do see the baggage handler who ran with the bag into the terminal re-emerge onto the tarmac and saunter slowly back to the plane and join the other baggage handlers unloading the rest of the bags. We comment to each other about the mysteries of running airports and how important that passenger must have been for their bag to receive such special treatment; and how that never seems to happen to our bags. That one bag got onto the baggage carousel ready for someone to take it very, very quickly. Why did the baggage handler do this? What was the point?

Managers of Heathrow Airport know customers like to be able to get their bags off the baggage carousel as soon as possible after they get off their plane. So they decided to set up a performance target of minimising the time it takes from when a plane docks at a gate to when the first bag gets onto the baggage carousel. The baggage handlers got a bonus if they met certain targets for the time taken to do this. And did this incentive work! The time taken to get the first bag off the plane and onto the baggage carousel plummeted and the baggage handlers got some handy bonuses. But did the customers get their bags off the baggage carousel any earlier? Well, no, except for the owner of the one bag that got the special ‘express’ service.

Managers soon realised this was not working so they changed the target to the time taken for the last bag to get onto the baggage carousel. Managers thought this might work a bit better. But it did not. Bags did not get onto the baggage carousel any faster. The reason for this was that there were often bags recorded as being on a flight that were put on the wrong flight or for some other reason did not make it onto the flight they were supposed to be on. So often the last bag did not get onto the baggage carousel for a day or more after the flight had landed, regardless of when the other bags were placed onto the baggage carousel. So this target did not work either. Managers then decided to set the target as the fourth last bag to be loaded onto the baggage carousel (which tells you something about how many bags might often get misplaced on each flight) and this target worked quite well to help baggage handlers reduce the time they took to unload bags from a flight (Otley, 2007).

What does this story about the baggage handlers show us? It shows us managers need to be very careful when setting targets and objectives for people in their firm, whether those targets are in numbers (such as time taken to unload the first bag from a flight) or in financial terms (that is, numbers with dollar signs in front of them). Managers need to think carefully about the links between the target measure and the behaviour of

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people and the outcome they are seeking to support and encourage by the target. Very often managers do not think carefully about this and set targets that can give the wrong incentives for people in a firm.

In fact, with setting budgets it can be even more complicated and difficult. This is because managers often set targets and budgets for outcomes for which they themselves will be held accountable. So why set the target too high? Often people can put in some slack or wriggle-room into their budgets; to ‘pad out’ the costs in their budgets and to underestimate revenue. The reason this is a serious problem with budgeting is that the people who set budgets for part of a business usually know more about that aspect of the business than those who will use the budgets to assess their performance. As a general rule, I have found it best not to tie people’s bonuses to performance compared to budgets. If you do, there will invariably be so much ‘game playing’ in the setting of budgets that it will be difficult to have confidence in the reasonableness of the forecasts underlying the budgets.

This section has looked at the reasons for budgeting. We have seen the central reason for a firm to budget is to support the detailed short-term implementation of managers’ plans for a firm. The use of accounting in the form of budgets to help managers do this is probably more of an art than a science. In the next section, we will consider some of the issues with preparing budgets and actually using accounting to help managers implement their plans in the short-term through the actions of others. As we do this, remember all of this involves people and not simply numbers on pieces of paper; it involves engagement of people in a firm with managers’ plans, dreams and objectives.

7.2 Preparing budgets

I find shoestrings very hard work. I like big budgets.

Julie Harris

The budget evolved from a management tool into an obstacle to management.

Frank C. Carlussi

This section discusses how budgets are prepared in a firm. We will look at who is best placed to prepare budgets for a firm, how budgets from various aspects of a firm can be brought together into an integrated master budget and how budgets can help us hold people accountable for parts of a business.

Participative budgeting

Never base your budget requests on realistic assumptions, as this could lead to a decrease in your funding.

Scott Adams

Wellington is the capital city of New Zealand. It was first settled by Europeans in 1840. It was surveyed and designed to have 1,000 one acre sections of land in the town centre surrounded by a green town belt. Outside the town belt were 1,000 one hundred acre sections. The plans of Wellington, including the layout of the roads, were finalised in London in the UK by people who had never been to Wellington. They had never made the arduous and dangerous voyage from London to Wellington. Dixon Street in Wellington goes in a nice straight line from Courtney Place, now an entertainment district in Wellington, crosses Willis Street and ends at The Terrace. The only problem is that Wellington is very hilly and there is about a 40 metre steep rise from Willis Street to The Terrace.

The plan for Dixon Street has the road going straight up essentially a ‘cliff’. That is how road maps in Wellington still have it. Only thing is the road stops between Willis Street and The Terrace and there are steps you need to walk up to get up the ‘cliff’ to the rest of Dixon Street. You certainly cannot drive up it. So why is Dixon Street like this? Why design a road to go straight up a ‘cliff’? Well, the reason is those who designed this road (and others like it) in Wellington were never on the ground and did not take into account the fact that Wellington is extremely hilly. To those in London looking at the maps of Wellington it looked like everything

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was flat.

It is like this with setting budgets. Budgets are a design for a firm’s short-term future. Who should put these designs together? Should it be someone sitting in head office who may never have set foot in some of the factories, warehouses or retail stores of a firm; and who may never have even met many of the staff who will actually have to carry out the budget? Or should it be people on the ground, working at the ‘coal face’ of different aspects of a firm’s operations? Participative budgeting is when lower level managers and staff are part of the process of preparing budgets.

I was a director of Donaghys for a number of years. At the time, Donaghys made and sold a number of products including a range of rope and cordage products. The budgeting process would start with a sales budget being prepared for each of Donaghys’ products, for example various types of bailing twine (such as Advantage 5000, Bulky 240 and Big Blue), mussel ropes (such as Aquatuff) and yachting braids (such as Yachtmaster XS and Dockline). Sales managers would prepare these budgets. Production managers, those responsible for manufacturing the products, would prepare production budgets setting out how much of each product could be produced in the factories. Any issues between the sales budgets and the production budgets would be negotiated and discussed between the sales managers and production managers, with the general manager sales and general manager production negotiating major issues of concern.

The managing director would be involved, ensuring the overall budget was consistent with the longer-term strategic plan of the firm which he had negotiated with the directors. There might be quite a degree of interaction and going back and forward between various managers before a draft budget would be presented by the managing director to the board of directors. This draft budget would be discussed by the board and usually some aspects would be sent back for further negotiation and development until a budget was established for Donaghys that the board felt was realistic and a stretch for the firm and also met the requirements of the private equity investors in Donaghys in terms of return on investment. At this point, the board of directors of Donaghys would approve the budget. In this way, participative budgeting is where managers at various levels of a firm are genuinely involved in the preparation of budgets.

If we feel we have been involved in the setting of targets and goals we are likely to have greater ‘buy in’ and commitment to actually doing the work required to help make the plans a reality. Like any good idea, or any good painting for that matter, fakes and cheap imitations can abound. Managers, who may have little real skill or capacity for the challenges and personal engagement of leadership, can seek to ‘fake’ participative budgeting. These managers may set the budgets and plans themselves and then go through the charade of involving others in preparing plans and budgets and, wouldn’t you know it, everyone ends up agreeing to set the budgets and plans the manager wanted in any case.

Besides the obvious lack of integrity on the part of managers who deceive their staff in this way (who are the very people they will rely on to carry out the plans), such imitation participative budgeting does not work. This is because people are not stupid. They usually see it for what it is and they do not like it. Better to be up-front and simply say these are the budgets so let us all get on with it rather than to pretend that lower level managers and staff have a genuine input into their preparation if in reality they do not. Believe it or not, people do not appreciate being lied to particularly by those purporting to be their leaders in firms. However, where there is genuine participative budgeting by people throughout a firm, with everyone clear on the extent to which they are able to meaningfully contribute to the formulation of budgets, we then need to pull together all the budgets and plans from various parts of the firm into a coherent whole. After all, in each firm there is only one firm.

Master budgets

Coming together is a beginning; keeping together is progress; working together is success.

Henry Ford

All the budgets for various aspects of a firm (such as sales, marketing, production, distribution, customer service, human resources, finance and administration) are usually brought together in a master budget. A

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master budget is usually made up of a cash budget, a budgeted income statement and a budgeted balance sheet. It is a summary of the individual budgets for each function of a firm. The major benefit of preparing budgets is that they represent a future virtual world for a firm. A budget is an expected future that has not yet happened, but which is based on various things happening in the short-term which people in the firm are able to work towards. The power of budgets is that they can help us anticipate events before they happen and so give us the opportunity to take action now before we find ourselves in an emergency.

Time lags are not a manager’s friend. Managers need to respond quickly to the changing events of a firm. At one level, budgets help managers foresee potential issues in advance and so can help them react to potential situations before they occur. That is a mighty short time lag; a sort of negative time lag. This can be much more effective than seeking to do something after the event. A common issue in firms of any size is lack of co-ordination between different activities in a firm. One common area of disconnect or conflict can be between the sales and manufacturing activities of a firm.

Sales and production budgets

It is vital the various activities of a firm are co-ordinated. One key area is to ensure the budgeted production levels are consistent with the budgeted sales volumes and the budgeted inventory levels. In volume terms:

Production + Opening inventory = Sales + Closing inventory

Our opening inventory is how much of a product we have at the beginning of a budget period. It is common to budget for a one year period. Production is how much we produce in the period. Thus production plus opening inventory is how much of the product we have available to sell in the period. Sales plus closing inventory is where this product will end up in a period: it will either be sold to customers or retained in inventory in our warehouses or retail stores. If we are planning to sell more of a product than we can produce in a period plus what we have in inventory at the beginning of the period, then we have a problem. We are planning to run out of stock which means problems with unhappy customers, stressed sales assistants, grumpy sales managers and unmet sales budgets (and thus unmet profit targets for the firm). Budgets can help us see such looming problems in a virtual world of accounting and budgets before they enter the real world of our firm. This gives us the opportunity to address problems before anything happens.

Sales budgets will be developed by sales staff responsible for achieving them, building up the sales budget from forecasts for sales of each product. The sales managers will consider what is reasonable to achieve based on their understanding of customers, competitors’ actions and other relevant factors on the ground. Sales managers are usually the best people to assess these things. But, of course, the sales managers will be expected to achieve these targeted sales and their personal remuneration may be linked to achieving them. So sales managers might seek to have some ‘fat’ in their sales budgets, to make it easier for them to achieve or exceed their sales targets. Senior managers will usually to some extent seek to ‘out guess’ the sales managers and vice versa.

In the same way, production managers will seek to forecast what production levels are achievable for each product. For example, sales managers may be keen to sell products for which there is strong customer demand and to offer it in a range of colours and with other features which customers like. Production managers are usually keen to ensure their production facilities operate efficiently and long production runs of reasonably standard products can help them do this. The plans of sales managers may place considerable strain on the production facilities to deliver the quantities of products the sales managers want. So there needs to be a bit of ‘give and take’ between the sales and production managers. And most importantly, the sales and production budgets need to be consistent with each other and to tightly dovetail with each other.

We have seen how the various budgets for each part of a business can be combined into a master budget, which usually involves a cash budget, a budgeted income statement and a budgeted balance sheet. This master budget is a summary of the budgets for each function or aspect of a firm. A master budget helps ensure all the budgets of the firm are consistent with each other and fit together into a virtual future ‘world’ that might be possible for a firm. When we enter the management ranks of a firm we can expect to be

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confronted with budgets for which we will be held responsible. What might they look like and what might they be trying to tell us? We will consider these questions in the next section as we have a look at two of the budgets in a master or overall budget for a firm: the cash budget and the budgeted income statement.

7.3 Budgeting for cash and income

It’s clearly a budget. It’s got a lot of numbers in it.

George W. Bush

What do budgets look like? Well, there are no set formats or rules for what should be in budgets or what they should look like. So they will be different from firm to firm; much like the rest of management accounting. As we have seen, with management accounting there are no set rules imposed on managers about what they must do. Having said that, there are general patterns and ideas often followed by firms in the budgets they use, applying concepts from accounting that managers often find useful to help them better understand and engage with the economic and business realities of their firms. In this section we will look at what cash budgets, budgeted income statements and budgeted balance sheets can look like.

Cash budgets

The two most beautiful words in the English language are ‘check [cheque] enclosed’.

Dorothy Parker

Have a look at a reasonably typical (although highly simplified) cash budget set out in Figure 7–1 below. This cash budget is for Purple Chocolates, a new chocolate company establishing itself in a small building just around the corner from the Cadbury chocolate factory in Claremont in Tasmania. Have a look at the cash budget and think about what it tells you. It has various cash inflows, that is cash expected to come into the firm each month; and various cash outflows, that is cash expected to go out of the firm. It is about cash that is expected to flow into and out of the firm each month. Purple Chocolates is intending to launch three products initially: Dairiest Milk Bar®, Caramellow® and Hazel Nut, all wrapped in the company’s distinctive purple wrappers. They expect some sales will be made at its factory for cash and that most sales will be made to supermarkets and other retailers on 60 days credit terms. But in the cash budget it is only when cash is received by Purple Chocolates that counts, not when sales are actually made or when the chocolate bars are handed over to its customers.

Purple Chocolates will also have various cash outflows involving the purchase of direct materials (full cream milk, cocoa, butter, sugar and a secret ‘purple’ ingredient containing caffeine), direct labour (including employing some key ex-employees from Cadbury’s chocolate factory nearby) and also indirect costs or overheads (including electricity, council rates and building maintenance). These costs are included in the cash budget when they are expected to be actually paid not when they are expected to be incurred. For example, people will work in the factory for two weeks before they are paid their wages and salaries for that period. Purple Chocolates also plans to spend cash on some new machinery in the first month when it is starting up its operations. Some indirect costs (such as depreciation on machinery) do not involve Purple Chocolates paying any cash, so these would not appear in the cash budget. Also, Purple Chocolates’ shareholders plan to invest some new capital into the business at the beginning of the first month to help fund its activities. This also involves cash coming into the business.

When we add up all the cash inflows and deduct all the cash outflows we get the net cash flow. If this is a negative number (that is cash outflows are expected to be greater than cash inflows in the month) this is shown in brackets. The net cash flow for each month is added to the opening cash balance of Purple Chocolates at the beginning of each month (which is zero at the beginning of the first month) and in this way we can calculate our closing cash balance each month. The closing cash balance of Purple Chocolates each month then becomes its opening cash balance for the next month.

Take a little while to look at the cash budget for Purple Chocolates in Figure 7–1. That is right, have a careful

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look at it. Make sure you understand how the cash receipts from sales have been calculated from the sales budget that is also included in Figure 7–1. Remember, the cash receipts from sales each month is calculated as that month’s cash sales plus the credit sales of two months previously. As there were no sales before January, the cash receipts from sales in each of January and February are simply the cash sales for each of those months.

We are the Managing Director of Purple Chocolates. What does this cash budget tell us? What does it not tell us? Well, one thing it tells us is that (except for January) we expect the closing cash balance each month to be negative. This means we had better negotiate an overdraft facility with our bank right now. Otherwise, our friendly bank manager may be giving us a call before long and also we may find direct debits paying staff’s salaries or cheques sent to our suppliers of sugar and cocoa may not be paid by our bank. This will very quickly lead to unhappy employees and unhappy suppliers. This is one thing the cash budget of Purple Chocolates would tell us.

What else does the cash budget tell us? Well, it tells us that we expect total net cash flow for the six months ending 30 June to be negative $325,000 (see the Total column for Net Cash Flow in Figure 7–1). We can also see that we expect the net cash flow from Purple Chocolates to become positive in May because of a big increase in expected cash receipts from sales in that month. This big increase in expected cash receipts from sales in May is due to a big increase in expected credit sales in March (see the Sales Budget in Figure 7–1) which are paid in cash in May. This means we expect our negative cash balance to peak at the end of April at $825,000 and then start to decline.

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Purple Chocolates

Cash Budget

For the six months ending 30 June 2017

Jan

$’000

Feb

$’000

March

$’000

April

$’000

May

$’000

June

$’000

TOTAL

$’000

Cash Inflows

New Share Capital 1,500 0 0 0 0 0 1,500

Cash Receipts from Sales* 100 200 300 400 1,000 1,000 3,000

Total Cash Inflow 1,600 200 300 400 1,000 1,000 4,500

Cash Outflows

Direct Materials 0 300 300 300 300 300 1,500

Direct Labour 75 150 150 150 150 150 825

Overheads 0 300 300 300 300 300 1,500

Purchase of Equipment 1,000 0 0 0 0 0 1,000

Total Cash Outflow 1,075 750 750 750 750 750 4,825

Net Cash Flow 525 (550) (450) (350) 250 250 (325)

Opening Cash Balance 0 525 (25) (475) (825) (575) 0

Closing Cash Balance 525 (25) (475) (825) (575) (325) (325)

* Cash sales that month plus credit sales from two months previously

Sales Budget

Cash Sales 100 200 200 200 200 200 1,100

Credit Sales (60 days) 100 200 800 800 1,000 1,000 3,900

Total Sales 200 400 1,000 1,000 1,200 1,200 5,000

Figure 7–1: Purple Chocolates Cash Budget

However, life usually does not happen exactly as we expect. When arranging a bank overdraft with our bank we would need to ensure Purple Chocolates has some ‘head room’ in the amount of its overdraft facility in case the cash demands on the business prove to be greater than we expect. So we would be wise to arrange an overdraft facility of at least $1.0 million, and preferably say $1.25 million. Also, as Purple Chocolates moves forward into the year, we can compare actual cash flows with the expected cash flows in the cash budget each month. This allows us to reassess regularly the future cash requirements of Purple Chocolates in the light of

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actual experience. Further, cash receipts from sales are a major item in our cash budget. A key driver of this item is credit sales two months before, as credit sales are paid by customers in cash 60 days (or about two months) after the sale. As Purple Chocolates progresses into the year we can keep a careful eye on credit sales each month as that will have a major impact on our cash budget two months later.

So we have made a start. We have considered the cash needs of Purple Chocolates over the first six months of 2017. However, firms do not exist simply as some sort of two-way ATM dispensing cash at one end (the front) and having cash put in at the other end (the back). Cash flow is important. Run out of cash and you are out of business. It is as simple as that. But there is more to managing a firm than managing cash flow. For example, we need to add value to our equity investors by providing a return on their capital invested in our firm. To do this, Purple Chocolates has to earn profits.

Budgeted income statements

So we also need to budget for our income or profitability, which is a measure of our firm’s value add to its equity investors. We do this by pulling together our various functional budgets for our firm into a budgeted income statement. Spend some time having a look at the budgeted income statement for Purple Chocolates in Figure 7-2 below. I have included the budgeted income statement for the full six months. I could have included the budgeted income statements for each of the six months individually as we saw for the cash budget. However, to keep things simple so that you can see some of the important relationships and issues more easily, we will only focus on the full six months budgeted income statement rather than on the budgeted income statements for each month.

What does the budgeted income statement tell us about the expected outlook for Purple Chocolates for the six months ending 30 June 2017? The first thing to notice is that Purple Chocolates is expecting to make a profit of $825,000 in the six month period. This sounds good. Yet with the cash budget we saw that Purple Chocolates is expecting a net cash flow of negative $325,000 in the same six month period (see Net Cash Flow in the Total column in Figure 7–1). Is it possible that Purple Chocolates could be ‘losing’ cash of $325,000 while at the same time making a profit of $825,000? How could this be? Which one should we ‘believe’? Also, we see that the expenses of direct materials and overheads are each greater in the budgeted income statement in Figure 7-2 than are the cash outflows for direct materials and overheads in the cash budget (See the Total column for Direct Materials and Overheads in Figure 7–1). How could this be? Again, which one should we ‘believe’?

Purple Chocolates pays for its direct materials (such as full cream milk, cocoa and butter) one month after purchasing and receiving them. It pays for its overhead expenses (such as electricity) on average one month after it uses them. So you can see Purple Chocolates may pay for various expenses at different times to when it incurs or uses these expenses. Also, Purple Chocolates may receive cash from its customers at different times to when its sales are actually made. For these reasons, its cash budgets and budgeted income statements for a given period may not fully line-up with each other. Indeed, this is to be expected.

What this means is that managers need to keep a tight eye on both cash movements in their business and on revenues, costs and profits (regardless of when they actually involve movements of cash into and out of a firm). Having cash budgets and budgeted income statements can help managers do this. So why in the six months ending 30 June 2017 is Purple Chocolates budgeting to make a profit of $825,000 while also ‘losing’ $325,000 in cash? Part of it is timing lags between cash flows into and out of a firm compared to when the revenue is actually earned and costs incurred. But there are other reasons for this difference.

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Purple Chocolates

Budgeted Income Statement

For the six months ending 30 June 2017

$’000

Sales

Cash 1,100

Credit (60 days) 3,900

Total Sales 5,000

Less: Cost of Sales

Direct Materials 1,650

Direct Labour 825

Cost of Sales 2,475

Gross Profit 2,525

Less: Dep’n of Machinery 50

Less: Overheads 1,650

Net Profit 825

Figure 7-2: Purple Chocolates Budgeted Income Statement

To understand more about how our budgeted cash flow and profit can be so different, we need to look at changes we are budgeting for or expecting in our firm’s assets, liabilities and equity. We will do this when we look at the budgeted balance sheet of Purple Chocolates in the next section. This will complete our look at a firm’s master budget. A firm’s master budget provides a future virtual ‘world’ for a firm that is only one of many possible futures it potentially faces. Business is full of surprises; which is part of the captivating power of business. In the next section, we will also conclude our look at budgets by considering how accounting can help or hinder us to manage the many surprises in business that will inevitably happen no matter how well we may plan or budget for the future.

7.4 Responding quickly to surprises

The fool of nature stood with stupid eyes

And gaping mouth, that testified surprise.

John Dryden

In this section we will look at the third budget in a firm’s master budget, the budgeted balance sheet; and we will see what additional insights it can give us. This will complete our look at a firm’s master budget. But it is all very well to budget and plan. We know life and business is full of surprises. Time and again things do not work out as we expect or budget or plan. Sometimes things work out better than we expect. Other times, things

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turn out in ways we do not like. What happens when the unexpected happens, when things do not work out as planned, when we face ‘surprises’? What do managers do then?

In this section we will look at how accounting may help or hinder managers to keep track of what is going on in a firm and to quickly react to get things back ‘on track’ in a firm. We will see that it all comes down to people. As a result, nothing is straightforward for managers in responding quickly to surprises in a firm. Nothing may be straightforward; but can accounting help managers meaningfully ‘control’ a business and react quickly to surprises? Before we look at this issue we will look at the third budget in a master budget: the budgeted balance sheet.

Budgeted balance sheets

As well as budgeting for cash and income, a firm also usually budgets for its balance sheet items: assets, liabilities and equity. It does this in its budgeted balance sheet. Have a look at the budgeted balance sheet of Purple Chocolates as at 30 June 2017 in Figure 7-3 below. At the beginning of January, Purple Chocolates is not expected to have any balance sheet items. As at 30 June 2017 it is expected to have equity of $2,325,000. It is expected to have total assets of $3,325,000, involving inventory ($375,000), debtors ($2,000,000) and equipment ($950,000, net of accumulated depreciation). It is also expected to have total liabilities of $1,000,000, involving a bank overdraft ($325,000) and creditors ($675,000). From the budgeted balance sheet we can see one reason for Purple Chocolate’s negative budgeted cash flow is that the firm is expecting to increase its assets significantly, particularly its working capital (debtors and inventory). A firm’s cash budget, budgeted income statement and budgeted balance sheet can together give insights to managers about some key aspects of the short-term plans for a firm.

Once a virtual world of a firm has been set up with various budgets on electronic spreadsheets, we can then change some items and see what impact this has on our firm. For example, what would be the impact on our expected cash flow and profits if we are able to collect our debtors on average within 30 days rather than 60 days; or if our sales prove to be 10% less than we expect? This can help us understand some of the risks for our business in our budgets and forecasts. Now, short-term planning, setting budgets and understanding some of the risks for a firm are great. But once a firm starts to take actual steps forward in reality things are unlikely to work out exactly as we expect. How might budgets help us respond quickly to the surprises that are a natural part of being in business?

Responsibility centres

Accountability breeds response-ability.

Stephen R. Covey

Many firms are large and complex. They often operate in many different markets and in a number of locations, carry out a wide range of activities and are continually changing and developing their product and service offerings in response to changes in their environment and customer demand. This size, complexity and rate of change can make many firms seem difficult ‘animals’ to understand. They can seem like a complex blur, a large ‘black box’ difficult to penetrate and understand. Yet by breaking a business into smaller and smaller pieces it can become easier to understand and it can become easier to measure its performance and activity. This can make it easier to hold people accountable for results within a firm and also make firms more responsive to change and to ensuring manager’s objectives are achieved.

We looked at the idea of responsibility accounting in Section 5.4 in Chapter 5 above. Responsibility accounting is where we break a business into different units and measure the performance of those units in terms of accounting results. These units of a business can be departments, branches or divisions; they can be a function, or an activity or even a piece of equipment. Responsibility accounting is about tracing costs, revenue or profits to individual or small groups of managers in a firm. With responsibility accounting we assign responsibility for some aspect of a firm’s performance to an individual manager or small group of people. We then establish performance measures or benchmarks which an individual or small group is held responsible for achieving. We then evaluate periodically what actually happens compared with these performance measures

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and assign rewards to individuals based on this evaluation. Budgets for each unit of a business can provide a basis for responsibility accounting, by regularly comparing actual performance with budgeted performance.

Purple Chocolates

Budgeted Balance Sheet

as at 30 June 2017

$’000

Assets

Inventory 375

Debtors* 2,000

Total Current Assets 2,375

Non Current Assets

Equipment 1,000

Less: Accum. Dep’n (50)

Total Non Current Assets 950

Total Assets 3,325

Liabilities

Bank Overdraft 325

Creditors** 675

Total Liabilities 1,000

Equity

Share Capital 1,500

Retained Earnings/Loss 825

Total Equity 2,325

Equity + Liabilities 3,325

* Debtors are credit sales in May and June.

** Creditors are amounts owed to suppliers of materials ($300,000), having been purchased in June; wages owed to Employees

($75,000), being one-half of direct labour incurred in June; and amounts owed to suppliers of overhead expenses ($300,000), being

overhead incurred in June.

Figure 7-3: Purple Chocolates Budgeted Balance Sheet

Responsibility accounting involves breaking up a firm into bits and holding individuals or small groups of people responsible for the results (as measured by the accounting system) of each bit. In this way, managers of a firm have more of a chance of ensuring people in a firm are doing what managers want them to do and that ‘surprises’, which invariably occur in business, can be responded to quickly. Yet this whole idea of responsibility accounting depends not only on simply assigning responsibility to bits of a firm to individuals (or

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small groups). It also depends on being able to measure and evaluate performance of bits of a firm and to connect this evaluation of performance meaningfully to individuals who can actually do something about that performance, who are in some way the ‘drivers’ of that particular aspect of a firm. We will now look at how accounting can help or hinder managers to hold individuals meaningfully accountable to achieving outcomes for aspects of a business that is in line with the overall objectives of a firm set by managers.

Measuring performance

The purpose of measuring the performance of responsibility centres is to ‘reward’ people who perform well and to ‘punish’ in some way those who do not. What happens in firms and organisations that do not effectively measure and reward performance? Well, typically an increasing number of individuals in those firms can develop an ‘entitlement’ mentality, where they think the firm owes them a living. Self-serving practices by individuals can easily develop, unrestrained by any effective mechanism to adjust individual behaviours to conform to the overall objectives of a firm set by managers. This can lead to individuals over time becoming ‘dead wood’, similar to dead branches in a tree that are using up space on a tree but contributing little or nothing to the life and growth of the overall tree.

Many people see this sort of thing that can develop in firms and say, well, we better assign responsibilities, measure and evaluate performance against established targets and then meaningfully assign ‘rewards’ and ‘punishment’ to individuals as a result. But what happens if we do this, when we measure and reward performance in a firm? Well, it can all too often lead to unintended consequences. Indeed, to a whole lot of consequences not intended (and generally not liked) by managers who set up the performance management system in the first place. Indeed, the measures of performance can encourage behaviour consistent with the goals of a firm; but equally, they can all too easily encourage behaviour inconsistent with the goals of a firm. How could this be?

Think back to the example of the baggage handlers at Heathrow Airport in Section 7-1 above. Great care needs to be exercised in setting performance measures and targets. In particular, a lot of careful thought needs to be given to how the performance measures are connected to and support the objectives of managers in a firm. This is critical if the performance measures are to help align people’s objectives with those of the managers of a firm. They can all too easily encourage behaviours that are disconnected from (and, indeed, in conflict with) the objectives of managers, such as the baggage handler running with the first bag and getting it onto the baggage carousel regardless of when the other bags of passengers find their way onto the baggage carousel.

Another key to measuring performance is to ensure that the people whose performance is being sought to be influenced by the performance measurement can indeed meaningfully affect or change the performance measure being used. This does appear to be pretty obvious. However, it is not unusual for this to not be the case. For example, in 1998 a management buyout (MBO) of various Australasian operations of McKechnie plc included Methven (a New Zealand tap ware business) as a relatively small part of the larger Australasian group. The remuneration of the senior management team of Methven was significantly affected by the overall performance of the McKechnie Australasian group. Yet this group of managers in Methven could only meaningfully affect the performance of Methven which had limited impact on the overall group and they had little or no ability to influence the performance of other businesses in the group.

As it happened, the performance of Methven while part of the McKechnie Australasian group was strong, yet the performance of some other businesses in the group did not perform as well. The remuneration of senior managers of Methven was being significantly influenced by the overall performance of the McKechnie Australasian group even though they could only meaningfully affect performance of one relatively small part of the group. What was this approach to performance management achieving in reality? Well, if anything, it was fairly discouraging for the senior managers of Methven, rather than motivating them in a positive way. In 2001, the McKechnie Australasian group sold Methven to another MBO consortium made up of managers of Methven and private equity investors which ran Methven as a stand-alone business.

Now the senior managers of Methven were held accountable only for the performance of Methven itself which was actually something they could meaningfully influence. Methven subsequently performed strongly

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and was floated on the New Zealand Stock Exchange in 2004. When measuring performance of responsibility centres, whether whole companies, divisions, a small work team or even a piece of equipment in a firm, it is critical to ensure the individuals being held accountable for the performance of the responsibility centre are able to meaningfully affect or change the performance being measured; and that the performance being measured is clearly and carefully connected to the overall objectives of the managers of the total business.

Balanced scorecard

Of course, there is a lot more to a business than its accounting numbers. In the same way, there is a lot more to our personal lives than the dollars we earn from our labour and from our personally-owned financial capital we have invested. There is a lot more to our personal lives than the list of financial transactions in our monthly credit card statements. Yet the financial numbers of our credit card statements can tell us a lot about us. Money spent at upmarket clothing stores in Lambton Quay at Wellington, or on airplane flights, or at restaurants at various holiday locations in Fiji or at Port Douglas in Queensland, Australia; or perhaps money given in donations to Mary Potter Hospice in Wellington, or to World Vision or to Cancer Research; or perhaps money spent gambling on the TAB. Yes, our monthly credit card statements can tell us a lot about us. In the same way, financial measures in business can tell us quite a lot about a business. But if we combine financial measures with non-financial measures of a firm’s operations this might help us better connect with a firm’s economic and business realities and help us to make more realistic assessments of performance. This is the idea behind what has become quite a popular tool of management: balanced scorecards. Typically, a balanced scorecard can seek to support senior managers in a firm to measure and assess performance from a financial perspective (for example through accounting measures of financial performance); from a customer perspective (for example, through measures of customer satisfaction); from an internal business process perspective (for example, through measures of deliveries of order of products to customers ‘in full and on time’); and from a learning and growth perspective (for example, through measures of employee training and employee satisfaction).

However, balanced scorecards can easily be applied poorly in businesses and degenerate quite quickly into relatively meaningless ‘tick the boxes’ exercises. Nevertheless, if intelligently and thoughtfully applied balanced scorecards can usefully broaden the measures of performance from simply short-term financial measures to include measures of relevance to the more medium-term aspects of a business.

Conclusions

Managers need to lead their firms in the short-term to ensure a firm takes the appropriate ‘next steps’ on the longer journey of the firm. We have seen how budgets may help or hinder managers to do this. Budgeting is common in many firms. The reasons why managers might use budgets to help them manage firms are to support short-term planning, to co-ordinate different aspects of a firm in the short-term, to assist clear communication within a firm about the short-term objectives of a firm, to support delegation of decision-making in a firm and to help motivate staff. If used well, budgets have the potential to do all these things in a firm. But in practice there are many ‘traps’ for managers in using budgets effectively in a firm and many of these potential benefits can easily prove illusory. The key issue is that all these potential benefits of budgets involve the effect accounting numbers and budgets can have on people; and people, as we know, have their own intentions and motivations independent of those of management.

We saw there are potential benefits of participative budgeting which involves including many people in the process of framing budgets. We also looked at an overall master budget for a firm (cash budgets, budgeted income statements and budgeted balance sheets) and the role each can play in the short-term management of firms. We saw the role budgets can play in measuring the performance of responsibility centres and to help managers respond quickly to surprises, which are an inevitable part of business and, indeed, of life. The short-term is important for firms. It is the ‘next step’ on a long journey. Budgets can help or hinder managers in leading their firms in the short-term. Yet a key role for managers is to make decisions, to take charge and take the lead. Decisions made by managers can affect not only the short-term performance of a business but can also have long-term implications for firms. In the next chapter we will see how accounting can help or hinder managers to make effective decisions for their firms.

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Reference

Otley, D. 2007, Beyond performance measurement, keynote presentation Accounting and Finance Association of Australia and New Zealand (AFAANZ) Conference. 1–3 July 2007. Gold Coast, Australia. The story of the Heathrow Airport baggage handlers is based on a story provided by Professor David Otley, Lancaster University Management School in this keynote presentation.