Budgeting

Features

•Futuristic – usually one year duration

•Estimation of business units profit potential
•Prepared in Monetary terms
•The entire planning and control process of many companies is built
around budgets.
 Planning

1. Budgets are useful because they enhance:

• Communication
• Coordination
2. The process of developing a budget forces managers to consider:
• Goals
• Objectives
• Specify means of achieving them
 Control
1. Budgets are useful because they provide a basis for evaluating
performance.
2. Performance evaluation is carried out by comparing actual
performance with planned or budgeted performance.
3. Significant deviations from planned performance are
associated with three potential causes.

Significant Deviations From Planned Performance Are

Associated With
1. Poorly conceived budgets.
2. Business conditions may have changed.
3. Managers that have done a particularly good or bad job
managing operations.
 Developing the Budget

1. Budgets are prepared for

a. Departments.
b. Divisions.
c. Company as a whole.
2. The Budget Committee is responsible for approval of the budget:
a. Senior managers
b. President
c. CFO
d. Various vice-presidents
e. Controller.
3. Top-down approach is where goals are pushed down from
top management.
4. Bottom-up approach is where lower-level managers are the
primary source of information used in setting the budget.
 Types of Budget

 Time Period:
 Long term
 Short term
 Capacity
 Fixed budget
 Flexible budget
 Coverage
 Functional budget
 Master budget
 Zero Base Budgeting

Zero-based budgeting (ZBB) is a method of budgeting in which all

expenses must be justified for each new period. The process of zero-
based budgeting starts from a "zero base," and every function within an
organization is analyzed for its needs and costs. The budgets are then
built around what is needed for the upcoming period, regardless of
whether each budget is higher or lower than the previous one.
Advantages: Focused operations, lower costs, budget flexibility, and
strategic execution. When managers think about how each dollar is
spent, the highest revenue-generating operations come into greater
focus. Meanwhile, lowered costs may result as zero-based budgeting
may prevent the misallocation of resources that may happen over time
when a budget grows incrementally.
Disadvantages: It is time and resource-intensive. Because a new budget
is developed each period, the time cost involved may not be
worthwhile. Second, it may reward short-term perspectives in the
company by allocating more resources to operations with the highest
revenues. In turn, areas such as research and development, or those that
have a long-term horizon, may get overlooked.
 The Master Budget

Master Budget includes:

1. Sales budget
2. Production budget
3. Direct materials budget
4. Direct labor budget
5. Manufacturing overhead budget
6. Selling and administrative budget
7. Capital acquisitions budget
8. Cash receipts and disbursements budget
9. Budgeted income statement
10. Budgeted balance sheet
The Master Budget: Graphic
 Sales Budget

1. Sales budget is the first step in the budget process.

2. It comes first because other budgets cannot be prepared
without an estimate of sales.
3. Example: production estimates are based on forecast sales.
4. Companies use a variety of methods to estimate sales:
a. Econometric models.
b. Previous sales trends.
c. Trade journals and magazines.
d. Sales force estimates.
 Production Budget

Production forecasts are based on the following

relationships:
Finished units to be produced
=
expected sales in units
+
desired ending inventory of finished units
–
beginning inventory of finished units
 Direct Material Purchase Budget

1. Direct materials budgets depend on:

a. The amount needed for production
b. The amount needed for ending inventory.
2. Calculated as follows:
Required purchases of direct materials
=
amount required for production
+
desired ending inventory of direct materials
–
beginning inventory of direct materials
 Direct Labor Budget

Direct labor budget calculated by multiplying:

Number of units to be produced
x
Labor hours per unit
x
rate per hour
 Manufacturing Overhead Budget

1. Cost per unit of production of each variable cost item is

multiplied by the quantity of units produced.
2. Fixed costs remain relatively constant.
 Selling & Administrative Expense Budget
Selling and administrative expense budgets include:
1. Salaries.
2. Advertising.
3. Office expenses.
4. Other general expenses.
 Budgeted Income Statement

1. Sales figures come from the sales budget.

2. Cost of goods sold is based on unit cost of production (and the
direct materials budget).
3. Labor cost information comes from the direct labor budget.
4. Overhead cost information is provided by the manufacturing
overhead budget provides.
 Capital Acquisitions Budget

1. Acquisitions of capital assets such as:

a. Property
b. Plant
c. Equipment
2. Must be carefully planned because they consume
substantial cash reserves.
 Cash Receipts & Disbursements Budget
1. Managers plan for the
a. Amount of cash flows and the
b. Timing of cash flows.
2. VERY important budget because...The timing of cash
inflows and outflows may diverge substantially from the
income statement.
 Budgeted Balance Sheet
1. The last component of the master budget.
2. A function of all of the other budgets.
3. Sometimes referred to as a pro-forma balance sheet.
4. Used to assess the effect of planned decisions on future
financial position.
 Budgets as a Standard for Evaluation
1. Budgets facilitate control by providing a standard for evaluation.
2. The standard is the budgeted amount against which actual results are
compared.
3. Differences between budgeted and actual amounts are called budget
variances.
4. Material differences between actual and budgeted should investigated.
 Investigating Budget Variances

1. Variances may have three causes:

a. May be ill conceived
b. Conditions have changed
c. Job performance
2. Variances should be investigated.
3. Management by exception is an approach that is economical
and often used.
4. Only exceptional variances are investigated.
Illustration
Illustration
 Conflict in Planning and Control Uses of
Budgets
1. Conflict is inherent in the planning and control uses of budgets.
2. Result is that managers:
a. Pad their budgets.
b. Shift income between accounting periods to increase their
compensation.
 Why Budget-Based Compensation Can Lead
To Budget Padding and Income Shifting

1. Hurdle bonuses and variable bonuses are commonly used.

2. Two problems:
a. Managers have an incentive to “pad” their budgets resulting in
“slack” budgets that are easy to achieve.
b. Managers have an incentive to shift income from one accounting
period to another to achieve “hurdle” targets.
 Evaluation, Measurement, and
Management Behavior

1. Managers pay close attention to how their performance is measured

and evaluated.
2. Budgets are usually measured in amount
3. Some types of non-monetary measures of performance are likely to
be advantageous.
4. “You Get What You Measure!”
 Budgetary Control

1. In addition to:
a. Planning
b. Communicating goals
c. Coordinating activities
2. Budgets also facilitate control of operations.
 Fixed Budget
A budget designed for only one level of activity. Differences from the
budget can be misleading when an organization actually operates at a
different level of activity.

Flexible Budget
A budget designed to cover a range of activity. Can be used to compare
actual costs incurred to budgeted costs around that level of activity.
 Fixed and Flexible Budgets

1. Make sure that the level of activity used in the budget is equal to
the actual level of activity.
2. Production budgets are a function of planned sales.
3. If sales increases suddenly, production must increase to meet
demand , thus total variable production costs will rise.
4. A fixed budget is not adjusted for the actual level of production
and is not suited for performance measurement.
5. Semi variable expenses should be segregated into fixed and
variable
6. A flexible budget is a set of budget relationships that can be
adjusted to various activity levels. It is suited for performance
measurement.
 Numerical
A factory is currently running at 50% capacity and produces 5000 units of Rs.900
per unit as per details below:

Rs.
Material 500
Labour 150
Factory overheads 150 (Rs. 60 fixed)
Administrative overheads 100 (Rs.50 fixed)

The current selling price is Rs.1000 per unit. At 70% working, material cost per
unit increases by 2% and selling price falls by 2%

Estimate profits of the factory at 70% working by preparing a flexible budget.

Solution
 Numerical
The cost of an article at the capacity of 5,000 units is given under A below. The individual
expenses vary as indicated under B below:

Particulars A (Rs.) B (per cent)

Material cost 25,000 100 variable
Labour cost 15,000 100 variable
Power 1,250 80 (variable)
Repairs and Maintenance 2,000 75 (variable)
Stores 1,000 100 (variable)
Inspection 500 20 (variable)
Administration overheads 5,000 25 (variable)
Selling overheads 3,000 50 (variable)
Depreciation 10,000 100 (fixed)
Total 62,750
Cost per unit 12.55

Prepare the production cost budget at 4,000 units and 6,000 units.
Solution

1,000

1,500

100

1,250

1500
 Numerical
A factory engaged in manufacturing plastic buckets is working at 40%
capacity and produces 10,000 buckets per month.
The present cost break up for one bucket is as under:
Material Rs.10
Labour Rs.3
Overhead Rs.5 (60% fixed)
The selling price is Rs.20 per bucket. If it is desired to work the factory at
50% capacity the selling price falls by 3%. At 90% capacity the selling
price falls by 5% accompanied by a similar fall in the price of material.
You are required to prepare a statement of profit at 50% and 90%
capacities.
Comment on the profitability.
Solution
 Cash Budget
Cash Budget contains detailed estimates of cash receipts (cash inflow)
and disbursements (cash outflows) for the budget period or some other
specific period. The preparation of cash budget has the following
objectives:
1. It indicates the effect on the cash position of seasonal requirements,
large inventories, unusual receipts, and slowness in collecting
receivables
2. It indicates the cash requirements needs for a plant or equipment
expansion program
3. It points up to the need for additional funds from sources such as
bank loans or sale of securities and time factor involved
4. It indicates availability of cash for taking advantages of discount
5. It assists in planning the financial requirements of bond redemption,
income tax instalments and payments to pensions and retirement
funds
6. It shows the availability of excess funds for short term investments
 Period of Cash Budget
The period of time covered by a cash budget depends on the type of
business, management planning needs and cash position.
1. Operational cash planning: Cash budgets may be prepared
monthly, weekly or even daily to meet information requirements of
management
2. Short-range: Short range cash budgeting is prepared annually and is
in correspondence with the annual profit plan. It indicates cash
inflows and outflows as generated by the annual profit plan.
3. Long-range: Long range budgeting does not disclose detailed
estimates of revenue and expenses. The effects of business
expansion and long-term trends are incorporated in long range cash
budgeting. Long range cash projection is in accord with (i) the
timing of the capital expenditure projects, and (ii) the timing of the
long range profit plan (usually five years)
 Preparation of Cash Budget
A cash budget may be prepared by either of the following three generally
accepted procedures:
1. The receipts and disbursements method: All anticipated cash
receipts (cash sales, cash collection from debtors, dividends,
proceeds from sale of assets, bank loan) are carefully forecasted.
Cash disbursements for material purchases, supplies, salaries,
repayment of loans, dividend, taxes purchase of plant & equipment
are determined. This method is used for short range cash projections.
2. The adjusted net income method: Starting point is the budgeted
profit. It is converted from accrual basis to cash basis. (like a cash
flow statement)
3. Balance sheet method: Closing balance of all budgeted balance
sheet items except cash and bank balances are found and put in a
budgeted balance sheet. The difference will determine cash balance
or shortage of cash balance
 Cash Budget
Quarter
 Numerical
Prasad & Co. wishes to prepare cash budget from January. Prepare a cash budget for the first six
months from the following estimated revenue and expenses:
` Total Sales (Rs.) Materials (Rs.) Wages (Rs.) Production Selling &
overheads (Rs.) Distribution OH Rs.
January 10,000 10,000 2,000 1,600 400
February 11,000 7,000 2,200 1,650 450
March 14,000 7,000 2,300 1,700 450
April 18,000 11,000 2,300 1,750 500
May 15,000 10,000 2,000 1,600 450
June 20,000 12,500 2,500 1,800 600

Additional Information
1. Cash balance on 1st January was Rs.5000. A new machinery is to be installed at Rs.10,000 on credit,
to be repaid by two equal installments in March and April
2. 2. Sales commission @ 5% on total sales is to be paid within a month of following actual sales
3. Rs.5000 being the amount of 2nd call may be received in March. Share premium amounting to Rs.
1000 is also obtainable with the 2nd call.
4. Period of credit allowed by suppliers – 2 months
5. Period of credit allowed to customers – 1 month
6. Delay in payment of overheads – 1 month
7. Delay in payment of wages – ½ month
8. Assume cash sales to be 50% of total sales
 Solution

Cash Budget - Jan to Jun

Jan Feb Mar Apr May Jun
Opening balance 5000 9000 14900 13500 12350 16550
Sh cap + premium 6000
Sales receipt 5000 10500 12500 16000 16500 17500
Total cash receipt 10000 19500 33400 29500 28850 34050
Outflows:
Machinery 5000 5000
Sales commission 500 550 700 900 750
Payment to suppliers 10000 7000 7000 11000
Prod OH - 1 m delay 1600 1650 1700 1750 1600
S&D OH - 1 m delay 400 450 450 500 450
Labour - 1/2 m delay 1000 2100 2250 2300 2150 2250
Total cash outflow 1000 4600 19900 17150 12300 16050
Closing cash balance 9000 14900 13500 12350 16550 18000
End of Topic