Evaluating a Company's Budget Procedures

Reducing the Estimated Direct Labor-Hours

1) Impact of reducing the estimated direct labor-hours

Shaving 5% off the estimated direct labor hours would result in a slightly higher overhead rate. If one is using an overhead rate based on direct labor hours, they essentially calculate the cost per unit for each product using direct labor hours to assign all overhead costs utilized in the production process. Keeping the overhead costs constant, an increase in direct labor hours would mean that one spreads the overhead costs across a larger number of units, whereas a decline in the direct labor hours would result in one spreading the overhead costs over a smaller number of units. Spreading the overhead costs over a small number of labor units means one will get a predetermined overhead rate based on direct labor hours.

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The application that uses a predetermined overhead rate based on direct labor hours to allocate manufacturing overhead can either result in overhead costs lower than what a firm actually incurred, or overhead costs higher than what a firm actually incurred in a period. With a high overhead rate, a firm is likely to end up with overhead costs exceeding what it actually incurred. The inconsistency between the overhead costs actually incurred and the overhead budgeted necessitates adjustments to ensure the cost accounting information is relevant and reliable. One way of making adjustments is by allocating the excess or deficient manufacturing overheads to the work in process, finished goods and cost of goods sold accounts.

When a firm has underapplied the manufacturing overhead, it credits the deficiency to the cost of goods sold, finished goods, and the work in process accounts. On the other hand, if a firm has over-applied the manufacturing overhead, it debits the excess overhead costs off the cost of goods sold, finished goods, and work in process accounts. The other way of making adjustments to correct the difference between actual and applied overhead costs is by crediting the deficiency to the cost of goods sold account, or debiting the excess off the cost of goods sold account; this approach is however less accurate compared to the first one.

In either approach, adjusting for over-applied overheads results in a decrease in the cost of the manufacturing output. Therefore, shaving 5% off the estimated direct labor hours can result in a high predetermined overhead rate that causes the over-application of manufacturing overheads. Correcting the excess overhead would see a reduction in the cost of production, and with a lower cost of production, the net operating income at the end of the fiscal year becomes higher.

2) The appropriateness of reducing labor hours in the computation of the predetermined overhead rate

Terri Ronsin should not agree to the general manager's request to shave 5% off the direct labor-hours estimate used in calculating the predetermined overhead rate. The only reason why reducing labor hours used to estimate the overhead rate is to have a boost in the net income at the end of the fiscal year. Accounting ethical standards require ensuring that the information presented in financial statements is reliable. If accounting information is reliable, the users of financial statements can depend on them to have material accuracy and as a faithful representation of the information they purport to present.

Significant misstatements during the preparation of financial statements reduce reliability. Shaving 5% off of the direct labor hours used to compute the predetermined overhead rate would constitute a significant misstatement of material information, which implies that Terri Ronsin would have breached her ethical duty of ensuring the reliability of the information presented in financial statements. Besides the breach of ethical duty, Terri Ronsin, by agreeing to the general manager's request, will create problems resulting from the use of inaccurate information to make business decisions. For instance, the firm's board of directors could decide to launch growth initiatives based on the profit the firm has earned at the end of the fiscal year. Such initiatives would call for the investment of a considerable amount of the firm's resources. If, using incorrect profit figures from previous years, the firm's board projects that investing in growth initiatives would result in high returns for the shareholders, the shareholders will have to shoulder the risk of investing resources in non-viable initiatives.

The attempt to use incorrect figures in computing the overhead rate can also cause operational problems. The production manager needs about 440,000 direct labor-hours to meet the current year's sales projections. The current year will also see the firm utilize at least 430,000 direct labor-hours, and the figure could go up in the subsequent year considering the projected increase in sales. If the general manager insists on having 420,000 direct labor-hours, the corporate headquarters is likely to cap the labor budget at the wage bill for 420,000 direct labor-hours. With inadequate resources to pay for the current year's labor requirements, the firm could be forced to operate below its full capacity, resulting in a decline in the returns to the shareholders. Overall, from an ethical and economic perspective, it is not appropriate for Terri to accept the general manager's request.

Budget Account System Evaluation

1) Problems in Budgeting System

It seems that the budgetary system is not based on sound forecasting that can generate reliable data for use as the basis of budgeting. Emory says that whenever they meet the budget, their seniors tighten it on them. That the seniors tighten things whenever the junior employees meet the budget implies that there are no reliable figures that the managers use to evaluate actual performance. It is also apparent that there are no clearly-defined goals of budgetary control. If the senior managers always force Emory to tighten the budget whenever he meets it, there are clear indications that the budgeting and budgetary control system does not rest on specific goals. The lack of specific goals reduces the effectiveness of the system because departmental managers do not know where to focus their efforts, besides lacking clear yardsticks against which to evaluate the performance of their departments to ascertain the progress towards the goals.

Another problem with the budgeting and budgetary control system is the lack of participation. It seems that the company controller and other senior staff do not consult the people responsible for attaining the targets in the budget at the formulation stage. Emory has concerns about the feasibility of the targets they have been handed by the company controller; he claims that it is not possible to work faster and attain quality at the same time. The failure to consult the people who oversee the implementation of the budget means the budget does not incorporate the operational context in which it is supposed to be implemented, making it less effective as a managerial tool.

In addition, handing unrealistic targets to junior employees makes them lose motivation. Emory says his men are ready to quit trying, a clear indicator that unrealistic targets have pushed their morale to the limit. If the people responsible for implementing a budgetary control system lack sufficient motivation, the system will lack effectiveness. There is also the problem of flexibility. The budgetary control system does not seem to consider contingent factors that affect the performance of various departments. A case in point is Emory's lamentation that the performance reports do not tell the whole story because small orders have prevented his department from focusing on the big jobs. He goes on to say that the setup and machine adjustment time has exacted a tremendous toll on his department's effectiveness.

When the budgetary control system is inflexible, managers essentially evaluate actual results against inappropriate yardsticks because contingent factors create significant variations between the context of formulating the budget and that in which departments attain the operating results. As such, an inflexible budgetary control system becomes ineffective as a planning and management tool. Another problematic aspect of the budgeting system is inadequate coordination. Emory laments that the demands of the sales department always create pressure for the scheduling department, which indicates that various departments have incongruent goals. Improper coordination results in the imposition of unrealistic targets, and comparing actual performance to unrealistic targets might not reveal useful information for managerial decision-making.

2) Revising the Budget System

The firm needs to revise the budgeting system so it uses a sound forecasting system as the basis for deciding on budgetary targets. Sound forecasts will ensure that the firm uses reliable data to set targets for various departments, which, in turn, will enhance the effectiveness of the budgeting system. An effective system is one in which the budgetary targets are a true reflection of the operating context of a firm's departments; in such a situation, budgetary control provides useful information for planning and management purposes.

It is also important to have specific objectives that the firm is trying to attain through the budgeting system. Clear and specific objectives will address the department manager's concerns about the company controller pressuring them to tighten things whenever they are on budget. The formulation of the budget needs to be an inclusive process that considers the views of the people tasked with implementing the budget. Enhancing the inclusiveness of the budget formulation exercise will ensure that the targets set in the budget are realistic and can provide an effective control mechanism when managers compare them to actual results.

The firm should also revise its budgeting system to ensure it is flexible. A flexible system will incorporate the contingent factors that arise in the period between the formulation of the budget and its implementation, making the budget system more useful in generating important information for planning and decision-making. There should also be an improvement in coordination, especially during the formulation phase. Various departments should have consultations on how their targets will impact each other. For instance, the sales department should consult the manufacturing department before deciding on the sales target for a particular period. Effective coordination will go a long way in enhancing goal congruence among various departments in the firm.