Cima P2 Exam Question 32

Question No 32:

KL is a transport company that has recently won a five-year government contract to provide rail transport services. The company appointed a new Director to take responsibility for the government contract. She has worked in various positions in other rail transport companies for a number of years. She has put together a team of managers by recruiting some of her former colleagues and some of KL’s current managers.

The contract stipulates that the company should prepare detailed budgets for its first year of operations to show how it intends to meet the various operating targets that are stated in the contract. The new Director is undecided about whether she should prepare the budgets herself or whether she should involve her management team, including the newly recruited managers, in the process.

Required:
Produce a report, addressed to the new Director, that discusses participative budgeting.

Note: your report must

A) Explain TWO potential benefits and TWO potential disadvantages of involving the new and existing managers in the budget setting process.

B) Provide a recommendation to the new Director.

(10 marks)

Answer:

A)An original budget is determined by predicting the expected level of activity and using standard costs to determine the expected variable cost for that level of activity. To this would then be added the expected fixed cost.
Standard costs are based on estimated resource requirements and the expected price of those resources for each unit. These values are then multiplied by the expected activity level to determine the expected variable cost of that level of activity.
Budgets are a statement of the total costs, revenues and resource requirements expected for the budgeted level of activity. It is this budget that is approved by the Board of Directors and used as the basis of comparison with actual results. However, it is most likely that the actual level of activity will differ from that budgeted. In such circumstances a simple comparison between the actual results and the original budget would be both meaningless and unfair because some of the costs and the revenues vary with the level of activity. In order to make a fair comparison flexible budgeting must be used.
Flexible budgeting recognises that, within the original budget, there are some costs and revenues that are affected by the level of activity (variable) and others that are not affected by activity levels (fixed). Using this analysis it is possible to produce a flexible budget showing the expected costs and revenues of the actual activity level. This can then be compared with the actual costs and the differences (variances) used as a measure of performance.

B)In order to fairly measure performance actual activity must be compared with the original budget to understand why the actual activity level differed from those budgeted; and actual costs and revenues should be compared with the flexible budget to fairly measure the actual costs and revenues against those expected for the actual activity achieved. Thus it is important to understand the appropriate uses of each of the original and flexed budget and how standard costs are used to compile the original budget and assist in the preparation of the flexed budget for cost comparison purposes.