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5. Budgetary Control as a
control tool
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Budgetary Control
One of three main functions ofmanagement is control. The other two areplanning and directing & motivating
Budgets are the main tools for controlling:
Compare actual results with plannedobjectives
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Budgetary Control
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Budgetary Control
A formalized reporting system should : Identify the name of the budget report:
such as the sales budget or the manufacturing
overhead budget Frequency of the report
weekly or monthly
Purpose of the report
Recipient(s) of the report
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Name ofReport
Frequency Purpose Primary Recipient(s)
Sales Weekly Determine whether salesgoals are being met
Top management and salesmanager
Labor Weekly Control direct and indirectlabor costs
Vice president of productionand production departmentmanagers
Scrap Daily Determine efficient use of
materials
Production manager
DepartmentOverhead costs
Monthly Control overhead costs Department manager
Selling expenses Monthly Control selling expenses Sales manager
IncomeStatement
Monthlyand
quarterly
Determine whetherincome objectives are
being met
Top manager
Budgetary Control Reporting System
The schedule above illustrates a partial budgetary controlsystem for a manufacturing company. Note the frequency of
reports and their emphasis on control
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Benefits of budgets
1. Forces managers to do planning.
2. Realistic performance targets.
3. Basis for controllingwhat happens within theorganisation.
4. Helps coordinate the activities of the variouscentres that make up the business.
5. Communication managers exchangeinformation on ideas, etc.
6. Motivating tool if the process involves
staff.
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Budget classification
Static (fixed) budgets: prepared for onelevel of activity, usually around theforecasts made for sales.
Flexible budgets: a series of fixedbudgets set to different levels of salesactivity (or any other activity) within which
the organization may operate.
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Cost/volume relationships
Fixed costs: in total remain the same fora period of time and over a particularrange of activity.
Variable costs: in total tend to changeas the level of activity changes.
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Cost/volume relationships
Fixed costs: in total remain the samefor a period of time and over a particularrange of activity.
Variable costs: in total tend to changeas the level of activity changes.
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Budget processes
Zero-based budgeting: sets the initial
figures for each activity to zero.
Period budgets: developed for a specific
period of time, e.g. a month.
Rolling (continuous) budgets: arecontinually updated by periodically
adding a new incremental time periodand dropping the period just completed.
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Types of budgets
Revenue budgets: estimates of the income of anorganization from the sale of goods and/or provision ofservices for a specific period.
Operating budgets: estimate activities that will affect profit. From Wikipedia:An operating budgetis the annualbudgetof
an activity stated in terms of Budget Classification Code,functional/subfunctional categories and cost accounts. It contains
estimates of the total value ofresourcesrequired for theperformanceof the operation including reimbursable work orservices for others. It also includes estimates ofworkloadinterms of total work units identified by cost accounts.
Budgeted financial statements: show the estimated results
and projected financial position of a business. That isbudgeted revenue, balance sheet and statement of cashflows.
http://en.wikipedia.org/wiki/Budgethttp://en.wikipedia.org/wiki/Factors_of_productionhttp://en.wikipedia.org/wiki/Performancehttp://en.wikipedia.org/wiki/Workloadhttp://en.wikipedia.org/wiki/Workloadhttp://en.wikipedia.org/wiki/Performancehttp://en.wikipedia.org/wiki/Factors_of_productionhttp://en.wikipedia.org/wiki/Budget8/3/2019 5. Budgetary Control as Control Tool
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Types Of Budgets Sales budget: The sales budget is an estimate of future sales, often broken
down into both units and dollars. It is used to create company sales goals. Production budget: Product oriented companies create a production
budget which estimates the number of units that must be manufactured tomeet the sales goals. The production budget also estimates the variouscosts involved with manufacturing those units, including labor and material.
Cash Flow/Cash budget: The cash flow budget is a prediction of futurecash receipts and expenditures for a particular time period. It usually coversa period in the short term future. The cash flow budget helps the businessdetermine when income will be sufficient to cover expenses and when thecompany will need to seek outside financing.
Marketing budget: The marketing budget is an estimate of the fundsneeded for promotion, advertising, and public relations in order to marketthe product or service.
Project budget: The project budget is a prediction of the costs associatedwith a particular company project. These costs include labor, materials, andother related expenses. The project budget is often broken down intospecific tasks, with task budgets assigned to each.
Revenue budget: The Revenue Budget consists of revenue receipts ofgovernment and the expenditure met from these revenues. Tax revenuesare made up of taxes and other duties that the government levies.
Expenditure budget: A budget type which include of spending data items.
http://en.wikipedia.org/wiki/Production_budgethttp://en.wikipedia.org/wiki/Production_budgethttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Production_budgethttp://en.wikipedia.org/wiki/Production_budget8/3/2019 5. Budgetary Control as Control Tool
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Master budget
A combination of all the budgets of an organization.
Merchandising firm Professionalservices
Manufacturing firm
Sales budget Fees or fees & salesbudget
Sales budget
Purchases budget Professional &support labor budget Cost of productionbudget
Cost of goods soldbudget
Cost of supplies used Cost of goods soldbudget
Other operatingexpense budgets
Other operatingexpense budgets
Other operatingexpense budgets
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The Master Budget - Schematic
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Master budget
Irrespective of the type of organization, thefollowing budgets will be part of the masterbudget:
Statement of financial performance[revenue budget]
Statement of financial position [balance
sheet] Statement of cash flow
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Static Budget Reports
Projection of budget data at one level ofactivity.
Data for different levels of activity are
ignored. Actual results are always compared with the
budget data at the activity level in the masterbudget.
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Budget and Actual Sales Data
To illustrate the role of a static budget in budgetarycontrol, we will use selected data for Hayes Company.Budget and actual sales data for the Kitchen-mateproduct in the first and second quarters of 2005 are as
follows:
Sales First Quarter Second Quarter Total
Budgeted $180,000 $210,000 $390,000Actual 179,000 199,500 378,500Difference $1,000 $10,500 $11,500
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The report shows that sales are $1,000 under budget - an
unfavorable result. This difference is less that 1% of budgetedsales ($1,000/$180,000 =.0056), we will assume that topmanagement of Hayes Company will view the difference asimmaterial and take no specific action.
Sales Budget Report:First Quarter
HAYES COMPANYSales Budget Report
For the Quarter Ended March 31, 2005Difference
Favorable F
roduct Line Budget Actual Unfavorable Uitchen-mate $180,000 $179,000
The sales budget report for Hayes Companys 1st quarter is
shown below.
$1,000 U
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Sales Budget Report:Second Quarter
HAYES COMPANYSales Budget
For the Quarter Ended June 30, 2005Second Quarter
DifferenceFavorable F
Product Line Budget Actual Unfavorable UKitchen-mate $210,000 $199,500 $10,500 U
The second quarter shows that sales were $10,500below budget, which is 5% of budgeted sales($10,500/$210,000). Top management may conclude
that the difference between budgeted and actual salesin the second quarter merits investigation and willbegin by asking the sales manager the cause(s).
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Uses and Limitations
A static budgetevaluates a managerseffectiveness in controlling costs when:
Actual level of activity closely approximates themaster budget activity level, and/or
Behavior of the costs in response to changes inactivity is fixed, i.e. costs do not change say if salesis more than budgeted
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Flexible Budgets
A flexible budget projects budget datafor various levels of activity.
The flexible budget recognizes that the
budgetary process is more useful if it isadaptable to changed operatingconditions.
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Static Overhead BudgetBARTON STEEL
Manufacturing Overhead Budget (Static)Forging Department
For the Year Ended December 31, 2005Budgeted production in units(steel ingots) 10,000
Budget costs
Indirect material $ 250,000
Indirect labor 260,000
Utilities 190,000Depreciation 280,000
Property taxes 70,000
Supervision 50,000
$1,100,000
Barton Steel prepares the above static budget for manufacturing overheadbased on a production volume of 10,000 units of steel ingots.
(Budget based on 10,000units of production)
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If demand for steelingots has increased
and 12,000 units are
produced during the
year, rather than
10,000, the budget
report will show
very large variances.This is because the
comparison is based
on budget data based
on the original
activity level (10,000
steel ingots). Variablebudget allowances
have increased with
production.
BARTON STEEL
Manufacturing Overhead Budget Report (Static)Forging department
For the Year Ended December 31,2005
Difference
Favorable F
Budget Actual Unfavorable U
Production in units 10,000 12,000Costs
Indirect materials $ 250,000 $ 295,000
Indirect labor 260,000 312,000
Utilities 190,000 225,000
Depreciation 280,000 280,000
Property taxes 70,000 70,000
Supervision 50,000 50,000
$1,100,000 $1,232,000
Static Overhead Budget Report
$ 45,000 U
52,000 U
35,000 U
-0-
-0--0-
$132,000 ?
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Item Total Cost Production Per Unit
Indirect material $250,000
Indirect labor 260,000
Utilities 190,000
$700,000
Variable Costs per Unit
/10,000 units $25
/10,000 units 26
/10,000 units 19
$70
Comparing actual variable costs with budgeted costs
is meaningless (due to different levels of activity),variable per unit costs must be isolated, so the budgetcan be adjusted. An analysis of the budget data forthese costs at 10,000 units produces the aboveper unit results:
Ill i B d d V i bl
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The budgeted variable costs at 12,000units, therefore, are shown above.Because FIXEDcosts do not change intotal as activity changes, the budgetedamounts for these costs remain the same.
Illustration Budgeted VariableCosts
(12,000 units)Item Computation Total
Indirect material $25 X 12,000
Indirect labor 26 X 12,000
Utilities 19 X 12,000
$300,000
312,000
228,000$840,000
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BARTON STEELForging DepartmentManufacturing Overhead Budget Report (Flexible)
For the Year Ended December 31,2005
Difference
Favorable F
Budget Actual Unfavorable U
Production in units 12,000 12,000Variable Costs
Indirect materials $300,000 $ 295,000
Indirect labor 312,000 312,000
Utilities 228,000 225,000
Total variable 840,000 832,000
Fixed Costs
Depreciation 280,000 280,000
Property taxes 70,000 70,000
Supervision 50,000 50,000
Total fixed 400,000 400,000
Total costs $1,240,000 $1,232,000
Flexible Overhead BudgetReport
This budgetreport basedon the flexiblebudget for
12,000 unitsof productionshows thatthe Forging
Departmentis belowbudget-a favorabledifference.
$ 5,000 F
-0-
3,000 F
8,000 F
-0-
-0-
-0-
-0-
$8,000 F
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Developing the FlexibleBudget
Identify the activity index and the relevantrange of activity.
Identify the variable costs, and determine the
budgeted variable cost per unit of activity foreach cost.
Identify the fixed costs, and determine thebudgeted amount for each cost.
Prepare the budget for selected increments ofactivity within the relevant range.
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Flexible Budget -A Case StudyMaster Budget Data
Variable Costs Fixed Costs
Indirect material $180,000 Depreciation $180,00Indirect labor 240,000 Supervision 120,00
Utilities 60,000 Property Taxes 60,00
Total $480,000 Total $360,00
Fox Company wants to use a flexible budget for monthlycomparisons of actual and budgeted manufacturing
overhead costs. The master budget for the year endedDecember 31, 2005 is prepared using 120,000 directlabor hours and the following overhead costs.
STEP 1: Identify the activity index and the relevant range of activity:The activity index is direct labor hours and management concludes that therelevant range is 8,000-12,000 direct labor hours.
Flexible Budget A Case Study
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Flexible Budget-A Case StudyComputation of variable costs per direct labor hour
Variable Cost per
Variable Cost Computation Direct Labor HourIndirect material $180,000/120,000 $1.5
Indirect labor 240,000/120,000 2.0
Utilities 60,000/120,000 .5
Total $4.0
STEP 2: Identify the variable costs and determine the budgeted variable
cost per unit of activity for each cost.There are 3 variable costs and the per unit variable cost is found bydividing each total budgeted cost by the direct labor hours used inpreparing the master budget (120,000 hours).
Fl ibl B d t A C St d
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Flexible Budget - A Case Study Step 3: Identify the fixed costs and determine the budgeted amount for
each cost.
There are three fixed costs and since Fox desires monthly budget data,
the budgeted amount is found by dividing each annual budgeted costby 12 ($180,000/12 =$15,000).
Variable Fixed
Indirect material $180,000 Depreciation $15,000
Indirect labor 240,000 Supervision 10,000
Utilities 60,000 Property Taxes 5,000$480,000
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FOX MANUFACTURING COMPANYFlexible Monthly Manufacturing Overhead Budget
Finishing DepartmentFor the Year 2005
Activity Level 8,000 9,000 10,000 11,000 12,000
Variable Costs
Indirect materials $12,000 $13,500 $15,000 $16,500 $18,000
Indirect labor 16,000 18,000 20,000 22,000 24,000Utilities 4,000 4,500 5,000 5,500 6,000
Total variable 32,000 36,000 40,000 44,000 48,000
Fixed Costs
Depreciation 15,000 15,000 15,000 15,000 15,000
Property taxes 5,000 5,000 5,000 5,000 5,000
Supervision 10,000 10,000 10,000 10,000 10,000Total fixed 30,000 30,000 30,000 30,000 30,000
Total costs $62,000 $66,000 $70,000 $74,000 $78,000
Flexible Budget - A Case StudyFlexible Monthly Overhead Budget
Step 4: Prepare the budget for selected increments of activity within therelevant range.
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Flexible Budget - A Case StudyFormula for Total Budgeted Costs
VariableCosts
TotalBudgeted
Costs
FixedCosts +
From the budget, the following formula may beused to determine total budgeted costs at anylevel of activity.
For Fox Manufacturing, fixed costs are $30,000,
and total variable costs per unit is $4.00. Thus, at 8,622 direct labor hours, total budgeted
costs are:
$30,000 $4.00 x 8,622 $64,488
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Flexible Budget Reports
Another type of internal report
produced by managerial accounting.Two sections:
Production data such as direct labor hours
Cost data for variable and fixed costs
Flexible budgets are used to evaluate a
managers performance in productioncontrol and cost control.
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Graphic Flexible Budget Data
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Flexible Overhead Budget Report
$ 13,50018,000
4,50036,000
15,00010,0005,000
30,000$66,000
FOX MANUFACTURING COMPANYFlexible Manufacturing O verhead Budget Report
Finishing Department
For the Month Ended January 31, 2005Direct labor hours (DLH) Difference
Expected 8,800Actual 9,000
Budget at9,000 DLH
Actual Costs9,000 DLH
Favorable FUnfavorable U
Variable costs
Indirect materials $14,000 $500 UIndirect labor 17,000 1,000FUtilities 4,600 100 U
Total variable 35,600 400 FFixed costs
Depreciation 15,000 -0-Supervision 10,000 -0-Proper ty taxes 5,000 -0-
Total fixed 30,000 -0-Total costs $65,600 $ 400 F
In this budget report, 8,800 DLH were expected but 9,000 hours were worked.Budget data are based on the flexible budget for 9,000 hours.
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Management by Exception
Review of a budget report
Focus on differences between actual resultsand planned objectives
Guidelines for identifying an exception.
Materiality expressed as a percentage difference from
budget
Controllability
more restrictive for controllable items thanfor items that are not controllable by themanager
General Control Characteristics for Expense Centers
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General Control Characteristics for Expense Centers
BudgetPreparation
FOR ENGINEERED COST CENTER:
Unit costs (of activity) provide basis for operating budget. The volume isdetermined by another dept. e.g. Sales (a Revenue center) is responsible for
volume. The Expense center is responsible for cost/unit of item soldFOR DISCRETIONARY COST CENTER:
The magnitude of the job to be done, determines the cost budget. Work is oftwo types - CONTINUING WORK: & SPECIAL WORK.
Management Objectives budgetee proposes to accomplish pre-definedobjectives, and expects to measured on those objectives..
Generally, personnel costs are the most significant cost item.
IncrementalBudgeting
Applies only to DISCRETIONARY COST CENTER. Current expense level isthe starting point. Adjustments made for inflation & changes in workload.
DRAWBACKS: ( 1.) No re-examination of current exp. Level. ( 2.)Foradditional services, additional budget. OVERHEADS INCREASE, PERIOD!
Zero-basedreview
From scratch, i.e. De Novo, certain resources required for each activity.Questions asked (a) should the activity be performed at all? (b) At whatquality level? ( c) Is the current way, the right way? ( d) How much should itcost?
Improvement tools - Benchmarking & Re-engineering. May be downsizing
General Control Characteristics for
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General Control Characteristics forExpense Centerscontd
Cost Variability In ENGINEERED : costs proportional to short-term changes in
volume (for e.g. of sales). In DISCRETIONARY: Insulated from short-term fluctuations.Driven mainly by the annual budget.
Type of Financial
Control
In ENGINEERED : set standards & measure actuals against
them. Variances are dependent on volume. In DISCRETIONARY: comparision made with planned costs, inthe annual budget.
Measurement ofPerformance
In ENGINEERED : Cost/ unit, required level/ volume of delivery
In DISCRETIONARY: The stated level of activity must performed,at budget cost. Less than budget expenditure, could actually be abad sign! Performance is measured non-financial terms goodjob, on-time ERP implemented,
Expense centers (continued)
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Expense centers (continued)Comparing Budgeted and Actual Costs
Budgeted costs are target estimates.
It points to a goal to be achieved.
But, it is not written in concrete.
Actual costs are that were incurred during a given period.
The difference between the two could be either positive or negativevariances.
However, making conclusions on the basis of positive or negativevariances must be done carefully.
C t/E t i
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Cost/Expense center variances A few pointers
Dont rush to conclusions based on positive or negative variances.
Find the cause behind the variances.
Decompose the flexible budget variances for unit-related costs intoprice and quantity components.
Since analysis of variances for batch-related, product-sustaining,and facility-sustaining costs is not formalized and proceeds on an adhoc basis,
Use your common sense and rationale as a neutral evaluator.
Administrati e Centers & S pport centers
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Administrative Centers & Support centers
EXAMPLES: ADMINISTRATIVE CENTERS: Senior Corporate Management, SBU Management SUPPORT CENTERS: Provide services to other responsibility centers
CONTROL PROBLEMS: Difficult to measure output. Attempt to tangibalize, routinize. Possible for standard
services such as payroll, i.e. x hours for one persons processing. But most often, it isnot so easy to measure.
Lack of Goal Congruence: The support centers desire to give perfect services(likely be at increased input costs) may mitigate against the profitability of the
organization. However, it is difficult define the optimum level of service. In tough times, discretionary expenses are under the tightest control.
BUDGET PREPARATION: Normally an Expense Center budget contains the list of expense items with their
proposed budget & current years expense. Sometimes, when large budgets are involved different levels of discretion must
available to top management The minimum required for being in business Discretionary activities (with objectives & estimated costs) Proposed increases, other than due to inflation
R h & D l t C t
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Research & Development Centers CONTROL PROBLEMS
Difficulty in relating results to Inputs Better than Administrative centers, because often semi-tangible output can be
seen e.g. patents, new products, new processes.
An R&D project may be on for many years, before the company can seebenefits:
E.g. a new drug could take 10 years, before launch. NOW IT HAS COMEDOWN (say 3-5 years).
The importance of PLM solutions : It is difficult to establish the value of theoutput.
Not all products succeed in the market. Issues of timing, changing tastes,
LUCK MATTERS! It is difficult to even decide which area in research will even be useful
LACK OF GOAL CONGRUENCE The technical perspective is to develop the best, maximum features, .THIS
COSTS MONEY. But how much money to sink in , must be balanced properly The value R&D sees in its own baby, is not what customer sees! Here good
selling skills can make a big difference DISCUSSION : CISCO small / incremental projects. Continue if customer
confirms value. AGILE PRODUCT DEVELOPMENT METHODS- show value on day one, if
possible. Co-create along with customer. The concept of alpha & beta customers
Research & Development Centerscontd.
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p The R&D continuum:
Basic research, applied research, development to Product Testing. Basic research unplanned, only broad area of research is known (what we will
discover is completely unknown). As we move towards Product Testing activities and outcomes become more
measurable & predictable. Significant time between basic research & successful product.
XEROX started research in photo-optics. Took 24 years before the photo-copyingmachine was launched!
> 90% research efforts fail to generate profitable outcomes. A possible MCS solution: 15% of an engineers time can be spent on
innovation in any topic of personal interest.
The need to establish an innovation culture maximum new value uncovered
at minimum cost & risk . IBM, Microsoft, Apple, Google, .. Tatas are the only company in the league world class innovators
R&D Program Management What should be the optimum R&D budget
% of revenue (is typically industry specific i.e. pharmaceutical 19%, computers 10%,Mfg 3-5% )
The budget is modified only annually. Many projects have to be planned over thelong term. Expenses are calendarized.
Performance Measurement Compare actual expenses, with budgeted The concept of earned value. To measure the effectiveness of the project
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Marketing Centers Marketing involves two very different types of activities i.e. order-getting &
order fulfillment.
Order Getting Marketing: Include test marketing, sales force activity, advertising & sales promotion The sales target is critical control point. Expenses are less important. Order Book
is the most important number for a sales person. There is (should be) a good co-relation between expenses in sales promotion &
advertising. Expense budgets tend to be short-term / flexible. Costs tend to discretionary costs
Order Fulfilling Logistics: All activities after an order is received. Similar to an expense center like
manufacturing. The expenses are proportional to sales volume / number of transactions (i.e.
tend to be engineered costs)
OVERALL RESPONSIBILITY OF MARKETING : Generate Revenue
Revenue = no of units sold X price / unit >> both must be optimised. Measure of performance : Actual Revenue vs Budgeted, on an ongoing basis
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University Questions
1. Compare (any three) :
a. Rolling budget and zero based budget. ch 4 pg 155-6
b. Engineered cost and budget" and "Discritionery cost and budget". Ch4 pgs 154-157
c. ZBB vs. Traditional Budget ch 4 pg 155-6
2. What are the differences between Engineered Expense Center andDiscretionary Expense Center? Give your answer with respect tofollowing control characteristics. [18]
a) Budget Preparation.
b) Cost variability.c) Type of Financial Control.
d) Measurement of Performance.
Give examples to support your answer. {ch 4 pg 151-7}