24/02/20201LO2&3: BudgetingDr Fidelis AkangaLearning outcomesBy the end of this unit Explain the purpose and nature of abudgeting system Explain how budgeting is used for planningand control Understand the different types of budgets Explain the benefits of budget Prepare different budgets and explain howthey lead to the master budget24/02/20202Definition and Role of Budgets A budget is a quantitative expression of a proposedplan of action by management for a future timeperiod It can cover both financial and non-financial aspects(such as planned revenue, expenses, assets,liabilities and cash-flows) of these plans and acts asblueprint for the company to follow in the forthcomingperiod. Serves as an aid to planning and controlling anorganisation’s activities in order to achieve certainobjectives.Budgeting process24/02/20203Budgeting process The first step therefore must be determining theobjectives to be achieved, and this should befollowed by a process where all departmentsaffected are brought together so that they can allwork together towards a common goal. It is also very useful to look back at the previousyear’s performance. It can serve as a good yardstick for preparing thebudget for the coming year.Effects of Budgetary Control• Budgets are tools that by themselves are neither goodnor bad. How managers control budgets is the key totheir value. When administered wisely, budgets canserve the following useful purposes:1. Compel strategic planning including theimplementation of plans2. Provide performance criteria3. Promote communication and coordination within theorganisation; and4. Affect motivating and wider organisationalprocesses.24/02/20204Effects of Budgetary Control In order to use budgets as control mechanisms, it isnecessary that actual results are subsequentlycompared with the budgets and any necessarycorrective action taken. Budgeting is most useful when done as an integralpart of an organisation’s strategic analysis. Strategy can be viewed as describing how anorganisation matches its own capabilities with theopportunities in the marketplace to accomplish itsoverall objectives.Preparation of a budget Preparation of a budget requires a number steps: a) determining objectives b) identifying resources required c) estimating the cost of the requirements d) reviewing and coordinating objectives and resources,and assessing the financial consequences e) finally approving the budget.24/02/20205Preparation of a budget Given below are the main different types of budgetsprepared by organisations Sales, Production, Materials, Labour, Overhead, etcThe Sales Budget The sales budget shows projected salequantities and prices. Provides predictions of total revenue fromwhich cash reception from customers can beestimated. Provides data for constructing other budgets(production cost, selling and distribution, etc)24/02/20206Example 1• Using the information given below, preparethe following budgets for the month of May:1. Sales in quantity and value, including totalvalue;2. Production quantities.Example 1: Sales or RevenueBudget ProductQuantity(units)Price each(£)SalesAB C1 0002 0001 500100120140 ProductAProductBProductCOpening stockClosing stock1 0001 1001 5001 650500550 24/02/20207Solution 1: Sales or RevenueBudget ProductAProductBProductCTotalSalesquantitiesSelling pricesSales value1000*£100£100.0002000*£ 120£ 240.0001500*£ 140£ 210.000£550.000 Production Quantities Budget Sales qty.Ope. stock+ closingstock = Qty. needed – 24/02/20208Solution 2: Production QuantitiesBudget ProductAProductBProductCSales quantities+ Closing stock= Quantity needed– Opening stock= Production 1 0002 0001 5001 1001 6505502 1003 6502 050(1 000)(1 500)(500)1 1002 1501 550 Sales Budget Units x Selling price = Total Sales Example 2. Our Parents enterprises specialises in theproduction of winter coats. Budgeted sales(units) for the months of April, May, June andfor the quarter were 20.000, 50.000, 30.000,100.000 respectively. Each coat was sold for£16. Prepare a sales budget for the threemonths and the quarterly sales budget.24/02/20209Solution to Example 2Production budgetUnitsSales XAdd : Closing stock XLess : Opening stock ( X)Production required X24/02/202010Direct materials usage budget Direct material cost: i) Quantity of Materials/unit X production required= Total Quantity of materials ii) Total Quantity of materials X price per unit= Direct material costDirect Labour Cost budget Direct labour cost: i) Production units X direct labour hoursrequired = Total direct labour hours required ii) Total direct labour hours X Direct labourrate/hour = Direct labour cost24/02/202011Variable Production Overheadbudget Direct Variable Overhead cost: (Assumingbased on direct labour hours) i) Production units X direct labour hoursrequired = Total direct labour hours required ii) Total direct labour hours X VariableOverhead rate rate/hour = Direct variableoverhead costCash budget• A Cash Budget states all the cash inflows and outflowsfor a certain period of time.• Sometimes the cash budget is also called “Statementof budgeted cash receipts and disbursements”.• A cash budget is not the same as an income statement.• Main Differences with the Income Statement: Depreciation is not included Loans are includedDividends are included 24/02/202012Main elements of a Cash BudgetThe main elements of a cash budget are:– Cash collections from customers (IN)– Cash disbursements for purchases (OUT)– Cash disbursements for operating expenses(OUT)– Capital Expenditures (OUT)– Loans (IN)– Loan repayments (OUT)As you can see everything is either IN or OUT.Types of Budgets Flexible budgets Zero based budget Activity Based Budget (ABB) Kaizen Budget Continuous budget24/02/202013Flexible BudgetsKey assumptions of a flexible budget are:– Total variable costs change in direct proportion to changesin activity.– Total fixed costs remain unchanged within therelevant range. A flexible budget is the difference between the actual revenuesand the cost drivers If operating income increases relative to the budgeted amount,we refer to it as a favourable variance. But if the operatingincome decreases relative to the budgeted amount, we refer toit as unfavourable variance.Flexible BudgetsBenefits: Show revenues and expenses that should haveoccurred at the actual level of activity. May be prepared for any activity level in therelevant range. Reveal variances due to good cost control or lackof cost control. Improve performance evaluation.24/02/202014Zero Budgets It is also known as ‘priority-based budgeting’ It requires that all activities are justified and prioritised(cost-benefit analysis) before decisions are takenrelating to the amount of resources allocated to eachactivity. It focuses on programmes (extending childcarefacilities) or activities instead of functional departments. Budgets are compiled as if the programmes are beinglaunched for the first time – Projected expenditure forexisting programmes should start from zero.Zero BudgetsReasons for its lack of success: Too costly and time-consuming Insufficient information to support the process Other organizational and behaviour factors• Suited to non-profit organization and discretionarycosts (advertising costs; research & developmentcosts) and support activities in profit organizations24/02/202015Activity-Based Budgets (ABB) ABB aims to authorize only the supply ofthose resources that are needed to performactivities required to meet budgetedvolumes. Therefore, the starting point for preparingABB is the cost object by separating indirectcosts into homogenous activity cost pools.Activity-Based Budgets (ABB)ABB involves a four step process Determine the budgeted cost to perform each unit ofactivity at each activity area Determine the demand for each individual activitybased on budgeted, production, new productdevelopment, etc Calculate the cost of performing each activity Describe the budget as cost for performing variousactivities (rather than budgeted costs of functional orconventional value-chain spending categories).24/02/202016Kaizen Budgets Aims at continuously improving processes andreducing costs Concept can be applied to budgeting by incorporatingexpected cost reductions into the planned results of abusiness. The concept tends to yield gradual improvements overa long period of time and drive down costs below theircurrent levels on a continual basis Concept requires great planning by management andrequires sufficient time and resources to examine allaspects of the businessKaizen BudgetsProblems associated with Kaizen budgeting: Useful in the first few years to achieve initialreductions. If reductions are not achieved, cash flowsand profits too cannot be achieved leading toconsiderable unfavourable variances in thebudget24/02/202017Continuous Budgets The traditional annual budgets have been criticised: it istoo rigid and based on uncertain forecasts. An alternative approach is to break down the budget bymonths for the first three months, and quarters for theremaining nine months. As the year proceeds, the quarterly budgets are reviewedand then developed on a monthly basis. By adding and preparing a budget for a fifth quarter, a12-month budget is always available as the quarter justended and is dropped – continuous/rolling planningCriticism of Budgeting Encouragingthinking;rigidplanningandincremental Being time-consuming; Producing inadequate variance reports leaving the‘how’ and ‘why’ questions unanswered; Ignoring key drivers of shareholders value byfocusing too much attention on short-term financialnumbers; Being yearly rigid ritual;24/02/202018Criticism of Budgeting Tying the company to a 12-monthcommitment, which is risky since it is basedon uncertain forecasts; Meeting only the lowest targets and notattempting to beat the targets; Spending what is in the budget even if this isnot necessary in order to guard against nextyear’s budget being reduced;24/02/202019Reading List Drury, C. (2018), Management & CostAccounting, 10th Edition. Chapter 15.
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