1.4 Budgets for performance management
Budgets are mostly presented in financial terms although they often include non-financial data such as production units, sales units or number of direct labour hours. In these circumstances budgets may be used as a reflection of the performance of those responsible for specific areas of the operation.
An example would be a sales budget that measures the performance of the sales manager and the sales team. Similarly, a production budget measures the performance of the production manager and the output of production operations.
Senior managers of large organisations often delegate responsibility for a specific sub-section of the business to a lower level manager. The lower level manager has responsibility for the overall performance and control of that area. This area of control is known as a "responsibility centre". Examples of a responsibility centre include sales, production and marketing. The manager of each responsibility centre is usually involved in the preparation of budgets for that area. When a budget is developed for a particular area the manager is responsible for ensuring that budget targets are met.
The way that managers are held accountable for meeting budgets is by comparing the actual performance of their business unit against the standard for performance that is expressed in the budget. Often there is a difference between budget expectations and what occurs in real life. This difference is known as variance.
Variance is a difference or discrepancy between a stated expected result and an actual result.
When a manager does not meet his/her sales targets (negative variance), or exceeds his/her sales targets (positive variance), then there is variance. A manager who does not meet his/her sales targets might be asked to explain his/her performance while a successful manager may be rewarded.
Centres of responsibility are sometimes referred to as either cost centres or profit centres. Cost centres are those parts of the business where the only controllable financial information that is available relates to how much that section is costing the business. For example, the production line of the Creek Clothing Company has easily identifiable costs but it is more difficult to put an exact dollar value on the lines contribution towards profit.
Profit centres are where both revenue and cost elements are easily identifiable, and are controlled by the manager of that profit centre. The Melbourne sales office of the Creek Clothing Company would be a profit centre as it is easy to work out how much the office costs to run and how many sales can be directly attributed to it.
The Creek Clothing Company is an example of why the budget process must be undertaken with the full cooperation of managers who understand the budgeting process. Budgets should produce figures that represent expected performance under current operational conditions. One of the problems of budgeting is that the current operational conditions can change due to things such as market changes and economic conditions. It is therefore necessary to revise budgets to reflect any unforeseen changes so that the budget does not become unrealistic. If this is done budgets may continue to be used to measure performance of the people responsible for particular departments within the operation.
Another problem that may occur with budgets is that they may be used in such a manner that constrains innovation and creativity. Budgets that are strictly adhered to, and leave little room for trying new things, tend to restrict a manager to the old way of doing things. Budgets should also not be used as a means to unnecessarily restrict expenditure or to limit revenue generating activities.
Activity 5
- Is your work group or department a cost or profit centre? Explain why?
- Through discussion with a work colleague or study partner identify the difference as to why a given operational area is a cost or profit centre.
- How many different examples from your organisation can you come up with?
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