Chapter Three

Information for Budgeting,

Planning And Control Purpose
3.1 Objectives and concepts of budgetary systems
Concepts of Budget?
 A budget is a financial document used to protect future
income and expenses.
 It could also be defined as a formal statement of the
financial resources set aside for carrying out specific
activities in a given period of time.
 It is the most widely used means for planning and
controlling activities at every level of an organization.
 A budget indicates the expenditures, revenues, or profits
planned for some future date.
 The planned figures become the standard by which
future performance is measured.
 Budgeting is a proactive approach rather than a
reactive approach to managing resources.
 Budgeting makes it easier for governments,
government departments, businesses and
individuals with incomes and expenses of all sizes
to make conscious decisions about how they will
prefer to allocate their resources. Therefore,
 Budgeting is the complete process of designing,
implementing and operating budgets.
 The main emphasis in this is short-term budgeting
process involving the provision of resources to support
plans which are being implemented.
 Budgetary control is intimately connected with
budgets.
 The Chartered Institute of Management
Accountants, London defines Budgetary control as
“the establishment of budgets, relating the
responsibilities of executive to the requirements
of a policy and the continuous comparison of
actual with budgeted results either to secure by
individual action the objectives of that policy or to
provide a firm basis for its revision”.
 A budgetary control system secures control over
performance and costs in the different parts of a
business:
 The budget is a blue-print of the projected plan of
action expressed in quantitative terms and for a
specified period of time.
 The budgets put the plan in a concrete form and
follow up action to see that plan is adhere to
complete the system of control.
 In other words, while budgeting is the art of
planning, budgetary control is the act of adhering
to the plan.
 In fact, budgetary control involves continuous
comparison of actual results with the budgets and
taking appropriate remedial action promptly.
 Budget: financial roadmap of the organization
chx - prepared in advance
- futurity of objectives
- quantitative
Advantages - way of communicating
- as benchmark
- as a means of educating
- reducing wastages and losses
 Principal budget factor: Major constraints/limiting
factors/bottlenecks

Examples: sale materials

labor Availability of
BUDGETING IN THE CONTEXT OF CONTROL SYSTEM
THEORY
 A control system consists of a sensor which reports
information (a monthly operating statement).
 A comparator which measures performance (comparison
of actual with budget and identification of variances).
 An effector (management action to correct identified
deficiencies or opportunities).
ALTERNATIVE BUDGET SYSTEMS
 Incremental
 Zero based
 Flexible
 Rolling
Type: Activity Flexibility Time
Operating Static short term
Financial Flexible mid term & long term
INCREMENTAL BUDGETING
The traditional approach to budgeting,
known as incremental budgeting, bases the
budget on the current year's results plus an
extra amount for estimated growth or
inflation next year.
 It encourages slack and wasteful spending
to creep into budgets.
 concerned mainly with the increments in
costs and revenues which will occur in the
coming period.
ZERO BASED BUDGETING
 preparing a budget for each cost centre from a zero
base.
 Every item of expenditure has then to be justified in
its entirety in order to be included in the next year's
budget.
 ZBB rejects the assumption inherent in incremental
budgeting that this year's activities will continue at
the same level or volume next year, and that next
year's budget can be based on this year's costs plus an
extra amount, perhaps for expansion and inflation.
 In this way, every aspect of the budget is examined in
terms of its cost and the benefits it provides and the
selection of better alternatives is encouraged.
ROLLING BUDGETS : DYNAMIC CONDITIONS
• Rolling budgets (continuous budgets) are budgets
which are continuously updated by adding a further
period (say a month or a quarter) and deducting the
earliest period.
• Rolling budgets are suitable to organizations that
operate in Dynamic (Volatile) conditions.
• Actual conditions may differ from those anticipated
when the budget was drawn up for a number of
reasons as follows:
Organizational changes may occur.
A change in structure, from a functional
basis, say, to a process-based one
New agreements with the workforce about
flexible working or safety procedures
CONTINUOUS BUDGETS OR UPDATED
ANNUAL BUDGETS
 If the expected changes are not likely to be
continuous there is a strong argument that
routine updating of the budget is
unnecessary.
 Instead the annual budget could be
updated whenever changes become
foreseeable, so that a budget might be
updated once or twice, and perhaps more
often, during the course of the year.
FIXED AND FLEXIBLE BUDGETS
 A fixed budget is a budget which is set for a
single activity level and It remains unchanged
regardless of the level of activity.
 A flexible budget-is a budget which recognizes
different cost behavior patterns and is
designed to change as volume of activity
changes.
 They are designed to flex with the level of
activity.
 Flexible budgets are prepared using marginal
costing and so mixed costs must be split into
their fixed and variable components
• The fixed budget‘s main purpose is to serve as a
benchmark in performance evaluation.
• It seeks to define the broad objectives of the
organization.
• A fixed budget is a budget which is normally set prior
to the start of an accounting period, and which is not
changed in response to changes in activity or
costs/revenues.
• Fixed budgets(in terms of a pre-set expenditure limit)
are also useful for controlling any fixed cost, and
• particularly non-production fixed costs such as
advertising ,because such costs should be unaffected by
changes in activity level(within a certain range).
MASTER BUDGET
 Master Budget

Operating budget Financial budget. . .

(profit plan). . .

Focuses on the income Focuses on the

statement and effects that the
supporting schedules operating budget
or budgeted expenses. and other plans will
have on cash
balances.
Learning
Objective Steps in Preparing the Master Budget

1. Supporting data

2. Operating budget

3. Financial budget
 Order of components of master budget

Since the components of master budget

are interconnected, it requires some flow
of data among budgets.
Meaning:
one component budget flow to another
one
components are prepared in a specific
order
MASTER BUDGET
in
Manufacturing Firms
 Sales budget

 The first and basic components of Master budget.

 Shows total sales forecasted during the period.
 The products of expected sales in units and expected
price per unit.
 Accompanied by a schedule of expected cash
receipts.
 Method of forecasting sales: Delphi, Trend Analysis
& Mkt research:
Illustration:
 The Hampton Freeze planed to have quarterly unit
sales of 10,000, 30,000, 40,000 & 20,000 and 20 $
for each case.
 Hampton Freeze Inc
Sales Budget
For the Year Ended December 31, 2008

Quarters
1 2 3 4 Year
Budgeted sales 10,000 30,000 40,000 20,000 100,000

Selling price $ 20 $ 20 $ 20 $ 20 $ 20

Total Sales 0.2 m 0.6m 0.8m 0.4m 2m

 Schedule of Expected Cash Collections

shows the budgeted collections on sales

during a period.
As % ge of budgeted sales
prepared after sales budget and
Before cash budget.
 Ignores bad debts.
Illustration:
 Hampton Freeze assumes beginning A/R amounts
$ 90,000 & 70 % of sales are collected in the
period(quarter) sale is made and the remaining is
to be collected in the following quarter.
 Production Budget
 Showing planned production in units.
 Basing sale budget data
Manufacturing Merchandising
Budgeted sales units Budgeted sales units
+ Ending Units * + Ending Units *
− Beginning in Units − Beginning in Units
Planned Prod in Units Planned Purch in Units
*endings for the period are beginnings for the next period .
Illustration: company assumes an ending
inventory equal to 20% of the next quarter’s sales.
Beginning inv of the 1st quarter and ending
inventory of 4th quarter is assumed 2,000 & 3,
000 units respectively.
 The Direct Materials Budget
 shows the quantity of direct material that will be used in
production.
 Formula:
Budgeted Production during the Period
× Units of Direct Material Required per Unit
= Direct Material in Units Needed for Production
+ Budgeted Ending DM
− Beginning Direct Material
= Budgeted DM Purchases in units
X Cost per DM
Budgeted DM Purchases in Birr
illustration: The company planned to have an ending inventories
equal to 10% of the following
quarter’s production needs & each requires 15 pounds of sugar
(DM for each unit to be produced)& each costs 0.2 $ per unit
.
 Schedule of Expected Cash Payments

shows the budgeted payments on purchase

during a period.
As percentage of budgeted purchases
prepared after DM purchase budget and
Before cash budget.
Illustration:
At Hampton Freeze, the policy is to pay for
50 % of purchases in the quarter in which the
purchase is made and 50% in the following
quarter. Beginning A/p amounts $ 25,800.
 The Direct Labor Budget
 shows the direct labor-hours required to satisfy
the production budget.
 Formula:
Planned Production in units
× Direct Labor Hours Required per Unit
= Budgeted Direct Labor Hours Required
× Cost per DL Hours
= Budgeted Direct Labor Cost
Illustration:
 The company expects each case requires 0.40
direct labor-hour & each costs $15 per direct
labor-hour
•
 Factory Overhead Budget

• shows all the planned manufacturing costs, other than direct costs,
needed to produce the budgeted production level.
• It has two sections: variable and fixed OH costs.
 Two alternatives to prepare OH budget
1. 2.
Total Fixed OH Total Fixed OH
+ Total Variable OH + Variable OH(V. OH rate X =
Total OH Assumed variable OH Units)

− Depreciation = Total OH
= Cash Pay’t for FOH − Depreciation
= Cash Pay’t for FOH
Illustration:
 Variable OH $ 4 per DL-hour and the fixed OH costs is $60,600
per quarter. Depreciation = $ 15,000 per quarter
 Selling and Administrative Expense Budget
• Shows planned operating expenses other than manufacturing costs.
• Common in all businesses
• Formula:
Budgeted sales
X variable selling & Adm expense per unit
= total variable selling & Administration expense
+ Total fixed selling & Adm expense
= Total selling & Administration expense
- Depreciation
= Cash Pay‘t for selling & Administration expense
Illustration:
Variable OH costs $1.8 per DL-hour and the total fixed OH
costs is $ 99,000 per quarter. Depreciation = $ 10,000 per
quarter
 cash budget
 The cash budget is composed of four major sections:
1. The receipts section.
2. The disbursements section
3. The cash excess/deficiency section.
4. The financing section.
Format
Cash balance, beginning . . . . . . . . . . . . . . . . . . . . . . . . . XXXX
Add receipts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXXX
Total cash available . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXXX
Less disbursements . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . XXXX
Excess/deficiency of cash available over payments . . . . XXXX
Illustration:
 Beginning cash balance $ 42,500 borrowings at the beginning
of 1st & 2nd quarters $ 130,000 & $ 70,000 respectively.
 Budgeted Income Statement
 shows planned profit :
 for trading and profit and loss accounts
 The budgeted trading account is to disclose the
budgeted gross profit,
 while the budgeted profit and loss account is to
disclose the budgeted net profit before tax.
 serves as a benchmark for operating performance
measurement.
Illustration:
 Hint: Consider the total sale value , CGS , Selling
& administrative expenses and interest expense,
Budgeted Income Statement
 The Budgeted Balance Sheet

It is developed using data from the balance

sheet from the beginning of the budget period
and data contained in the various schedules.
Fore instance cash budget.
Illustration:
Hampton Freeze’s budgeted balance sheet
is presented using data taken from the
company’s previous end-of-year balance
sheet for 2007, which appears below:
Budgeted balance sheet
The End of
chapter 3
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