1. Accounting for Executives
Week 9
13/5/2010 (Fri)
Lecture 9

2. Learning Objectives 2. Reasons for producing budgets
1. Nature and purpose of budgets
2. Reasons for producing budgets
3. Methods of budget preparation
Budgets preparation
Budgetary controls 2

3. Nature & purpose of budgets
What is a budget?
A budget can be defined in terms of one or all of the following:
(a) A plan of action for a future period expressed in monetary and/or quantitative terms.
(b)A financial and quantitative statement of policy to be pursued.
(c )A plan prepared and approved prior to a defined period of time in order to attain the organizations objectives.
(d)A plan or target in quantities and/or money value prepared for a future period of time. 3

4. Budgeting cycle
Well-managed organizations usually have the following budgeting cycle:
a. Planning the performance of the organization as a whole and its sub-units.
b. Providing a set og specific expectations against which actual results can be compared.
c. Investigating deviations from plans and, if necessary, taking corrective action.
d. Planning again, in light of feedback and changed conditions. 4

5. Reasons for producing budgets
Plan the annual operations of the business.
Coordinating the activities of the various functions of the business.
Communicate the overall objectives and plans to all the employees of the organization.
Authorize future expenditure.
Motivate employees to achieve the organizational objectives.
Control the actual events to conform to the annual budget by analyses the variance between the actual and expected results.
Evaluate and reward the performance of managers. 5

6. Strategy and annual budget6

7. Strategy and planning Steps in formulating a plan for a business:
1. Identify the long-term objectives for the organization.
2. Produce a strategic plan which will help the organization’s long-term objectives to be achieved.
3. Develop the tactics or methods which are to be employed in implementing a strategic plan. 7

8. Methods of budget preparation
Various methods of budgeting
a) incremental budgets
b) zero-based budgets
c) fixed budgets
d) flexible budgets
a) Incremental budgeting
By using the current year figures as the base, the manager anticipate changes due to growth and/or reductions in demand for product / service and incorporate these changes in the current year figures to formulate the next year budget. 8

9. Incremental budgets
Pros and Cons for using the incremental budgeting technique
Easy to implement and time and cost saving as the level of operating activity of most business will not change dramatically from year to year
It continue previous inefficiencies and encourage wastage as the manager use the last year figure (e.g. maintenance expenses) as the base to estimate the next year’s spending, it disregards the fact that some items may be excessive in the current year but continue be included in the next year. 9

10. Zero based budget Zero based budgeting technique
This budgeting technique requires managers to prepare their budget as if the first year of preparing. Everything starts from a zero base, they are required to justify each item of spending and level of activity to be performed.
Pros and cons
It is more time consuming in preparing the budget, however, the ZBB approach does attempt to share and divert the resources according to need and benefit. This approach creates a questioning attitude and focuses on achieving value for money. 10

11. Fixed budget Fixed Budget
The budget is designed to remain unchanged irrespective of the volume of output or turnover achieved. Consequently, if the actual activity is considerably above/below budget, then significant variances are likely to occur. 11

12. Flexible budget Flexible budget
Managers are aware of the degree of variability of costs and the amount of costs of a fixed nature in a particular item of cost. As a consequence, it is possible to redraft budgets to reflect the cost for the level of activity attained. The flexible budget is designed to adjust the permitted cost levels to reflect the actual level of activity achieved. Where the principal factor on which the budget is based, for instance sales levels, is significantly different from budget, it may be appropriate to ‘flex’ the budget. 12

13. Fixed budget vs Flexible budget
Example
XYZ company manufactures and sells a single product X-7. X-7 has two variable- cost categories. The budgeted variable costs per unit of X-7 are as follow:-
Cost category Var. cost per unit($)
Direct materials $20
Direct labor costs $10
Total var. cost $30
The cost driver for direct materials and labor cost is the number of units mfg. The budgeted fixed overheads are $50,000. The budgeted selling price is $50 per unit. P.T.O 13

14. Fixed budget vs Flexible budget
XYZ Co. (Con’t)
The fixed budget for May 2005 is based on selling 1,000 units. The actual sales in May 2005 were 900 units.
Actual Fixed Budget Variances
Units sold 900 1,
Revenues $47,700 $50,000 $2,300 (U)
Variable costs
Direct materials $19,000 $20,000 $1000 (F)
Direct labor costs $9,500 $10,000 $ (F)
Fixed costs $5,100 $5,000 $ (U)
Operating income $14,100 $15,000 $ (U) 14

15. Fixed budget vs Flexible budget
Actual Budget Variances
Units sold
Revenues $47,700 $45,000 $2,700 (F)
Variable costs
Direct materials $19,000 $18,000 $ (U)
Direct labor costs $9,500 $9,000 $ (U)
Fixed costs $5,100 $5,000 $ (U)
Operating income $14,100 $13,000 $1,100 (F) 15

16. Fixed budget vs Flexible budget
1. Flexible is designed to change so as to related to actual volume achieved
2. It helps us to plan ahead what if different levels of activities come out, and enable the management to set up contingency plan
3. With periodic performance reports permit budget allowance and actual results to be pinpointed quickly so that corrective action can be taken right away.
4. The flexible budget is used as a control device by permitting a comparison between actual results with budgeted amounts. The use of flexible budgets allows a comparison between actual costs and what costs should be for the actual production level. 16

17. 5. Flexible budget help to reveal true price variances
5. Flexible budget help to reveal true price variances. If we compare the budget and actual cost at same level of activity, then only difference is price.
6. It prevents managers to hide the variances. For example, if budget is based on 1,200 units but actual activity is 1,000 units then actual cost understandably would be lower than the budget (which is based on 1,200 units). Managers would even be able to show favorable variances. 17

18. Budget administration
Budget committee
The group of managers/directors who are responsible for administering and coordinating the preparation of budgets in accordance with the organization’s objectives.
Members of the budget committee:
The president, treasurer, chief accountant (financial controller), and management personnel from each major area of the company 18

19. Budget administration
The budget committee will refer to the organization’s strategic plan which identifies the objectives for the next three to five years and identify the external factors that are likely to impact on the business during the budget period.
For example: Units to be closed and/or opened.
Products or services to be introduced and/or discontinued.
Economic forecasts
Competitor activity
Pricing policy
International developments
Marketing strategy
Forecasts of the timing and level of pay and price increases 19

20. Preparing budget
Budget preparation should be a bottom-up process. The budget originates at the lowest levels and is subsequently refined and coordinated at higher levels. 20

21. Master budget
Master budget The overall budgets of an organization, built up from a range of individual budgets and comprising the cash budget, the forecast profit and loss account, and the forecast balance sheet.
Two Classes of Budgets in the Master Budget
Operating budgets
the individual budgets that result in the preparation of the budgeted income statement
Financial budgets
focus on the cash resources needed to fund expected operations and planned capital expenditures 21

22. Component of a master budget22

23. Preparing budgets Sales budget
Manager prepares sales budget annually setting out the expected sales volume of the coming year. The budget is based on the manager’s forecast, although sometimes it is based on the results of marketing research.
Production budget
This is prepared after the sales budget. It involves preparing and costing a production plan to meet sales. Expected closing stock levels will also be included in the production budget to meet the expected demand at the opening of next period. 23

24. Preparing budget Departmental/ functional budget
This is prepared by the managers responsible for budgets in their departments/functions including, marketing, distribution, information technology, human resources, accounting, etc.
Capital expenditure budget
It is a fixed asset purchase budget. This normally covers actual fixed purchases in the next 12 months. The capital budget also identifies the depreciation charges arising during the next 12 months as these have to be built into production and departmental budgets. The capital budget indicates the cash requirements arising during the year. 24

25. Benefits of budgeting a) All levels of management plan ahead.
b) Definite objectives for evaluating performance.
c) Early warning system for potential problems.
d) Coordination of activities within the business.
e) Management awareness of the entity’s overall operations.
f) Motivates personnel throughout organization to meet planned objectives. 25

26. Sales Budget
The sales budget is prepared by multiplying the expected unit sales volume for each product by its anticipated unit selling price.
For DKK Company, sales volume is expected to be 3,000 units in the first quarter with 500-unit increments in each succeeding year. Based on a sales price of $60 per unit, the sales budget for the year by quarters is shown below: 26

27. Production Budget
Shows the units that must be produced to meet anticipated sales.
It is derived from the budgeted sales units (per sales budget) plus the desired ending finished goods less the beginning finished goods units.
The production requirement formula is:
Desired Ending Finished Goods Units
Beginning Finished Goods Units
Required Production Units
Budgeted Sales Units 27

28. Production Budget
DKK believes it can meet future sales requirements by maintaining an ending inventory equal to 20% of the next quarter’s budgeted sales volume. The production budget is shown below.
Per sales budget
Required production units , , , , ,400
20% of next
quarter’s sales
Expected st Q sales
5,000 units x 20% 28

29. Direct Materials Budget
Shows both the quantity and cost of direct materials to be purchased.
It is derived from the direct materials units required for production (per production budget) plus the desired ending direct materials units less the beginning direct materials units.
Direct Materials Units Required for Production
Desired Ending Direct Material Units
Required Direct Materials Purchases
Units
Beginning Direct
Materials
Units 29

30. Direct Materials Budget
DKK has found that an ending inventory of raw materials equal to 10% of the next quarter’s production is sufficient. The manufacture of Kitchen-mate requires 2 pounds of raw materials and the expected cost per pound is $4. Assume ending direct materials for the 4th quarter are 1,020 pounds. The direct materials budget is shown below:
from production budget
Total cost of direct materials
purchases $25, $29, $33, $37, $124,800 30

31. Direct Labor Budget
At DKK Company, 2 hours of direct labor are required to
produce each unit of finished goods, and the anticipated
hourly wage rate is $10. The direct labor budget is shown below.
DKK COMPANY
Direct Labor Budget
For the Year Ending December 31, 2005
QUARTER 1 2 3 4
Year
Units to be produced
(from Production Budget)
3,100
3,600
4,100
4,600
Direct Labor time (hours)
per unit
Total required direct labor
hours
6,200
7,200
8,200
9,200
Direct labor cost per hour
$10
Total direct labor cost $62,000 $72,000 $82, $92, $308,000 31

32. Manufacturing Overhead and Selling and Administrative Budget
Manufacturing overhead budget
expected manufacturing overhead costs
Selling and administrative expense budget
projection of anticipated operating expenses
Both distinguish between fixed and variable costs. 32

33. Manufacturing Overhead Budget
DKK Company expects variable costs to fluctuate with production volume on the basis of the following rates per direct labor hour (as calculated in the Direct Labor Budget).
Indirect materials $1.00/hr Indirect labor $1.40/hr Utilities $.40/hr Maintenance $ .20/hr
3,100 units X 2hrs
=6,200 hrs X $1
=$6,200
Total variable costs $18, $21, $24, $27, $ 92,400 33

34. Manufacturing Overhead Budget
Fixed costs complete the manufacturing overhead budget and
the totals are used to calculate an overhead rate, which will be
applied to production on the basis of direct labor hours.
Total manufacturing overhead $57, $60, $63, $66, $246,400
Direct labor hours , , , , ,800
Manufacturing overhead rate per direct labor hour ($246,400 / 30,800) = $8.00 34

35. Selling and Administrative Expense Budget
Variable expenses are based on the unit sales projected in the sales budget. The rates per unit of sales are sales commissions $3.00 and freight-out $ Fixed costs are based on assumed data and include $1,000 of depreciation per quarter.
Total selling and adm. ex. $42, $44, $46, $48, $180,000 35

36. Budgeted Income Statement
The important end-product of the operating budgets.
indicates the expected profitability of operations
provides a basis for evaluating company performance
The budget is prepared from the:
Sales budget
Production budget
Direct labor budget
Direct materials purchases budget
Manufacturing overhead budget
Selling and administrative expense budget 36

37. Computation of Total Unit Cost
To find cost of goods sold for the Budgeted Income Statement it is necessary to determine the total unit cost of a finished product using the direct materials, direct labor, and manufacturing overhead budgets.
Total unit cost $44.00 37

38. Budgeted Income Statement
Cost of goods sold can then be determined by multiplying the
units sold by the unit cost. All data for the statement are obtained
from the operating budgets except: interest expense ($100) and
income taxes ($12,000).
(From sales budget)
(15,000 x $44) 38

39. Preparing the Financial Budgets
Cash budget
anticipated cash flows
often considered to be the most important output in preparing financial budgets
The cash budget contains three sections:
Cash receipts
Cash disbursements
Financing 39

40. Basic Form of a Cash Budget
The cash receipts section includes expected receipts from the company’s principal source(s) of revenue such as cash sales and collections from customers on credit sales. 40

41. Basic Form of a Cash Budget
The cash disbursements section shows expected payments for direct materials, direct labor, manufacturing overhead, and selling and administrative expenses. This section also includes projected payments for income taxes, dividends, investments, and plant assets. 41

42. Basic Form of a Cash Budget
The financing section shows expected borrowings and the repayment of the borrowed funds plus interest.
This section is needed when there is a cash deficiency or when the cash balance is below management’s minimum required balance. 42

43. Collections from Customers
Preparing a schedule of cash collections from customers is useful in preparing a cash budget. Assuming that credit sales per the Sales Budget (amounts shown in parentheses below) are collected 60% in the quarter sold and 40% in the following quarter. Accounts Receivable of $60,000 at December 31, are expected to be collected in full the first quarter of 2005.
$ 180,000 X 60% = $108,000
$ 180,000 X 40% = $72,000
$ 60,000
108, $72,000
126, $ 84,000
144, $96,000
162,000 43

44. Payments for Direct Materials
A schedule of cash payments for direct materials is also useful in preparing a cash budget. Assume that 50% of direct materials purchased are paid for in the quarter purchased, 50% are paid in the following quarter, and an accounts payable balance of $10,600 on December 31, 2004 is paid for in the first quarter of The schedule of cash payments will be as follows:
Amounts in parentheses
taken from direct material
purchases budget
$10,600
12,600 $12,600
14,600 $14,600
16,600 $16,600
18,600 44

45. Cash Budget
Assume that ending cash is $38,000 for 2004 and marketable securities are expected to be sold for $2,000 cash in the first quarter. Collections from customers was calculated in slide 27. The receipts section of the DKK Company cash budget is shown below: 45

46. Cash Budget Additional information
Direct materials amounts: taken from the schedule of payments for direct materials.
Direct labor amounts: taken from direct labor budget-100% paid in quarter incurred.
Manufacturing overhead and selling and administrative expense amounts: all items except depreciation are paid in the quarter incurred.
Management plans to purchase a new truck in the second quarter for $10,000.
The company makes equal quarterly payments ($3,000) of its estimated annual income taxes. 46

47. Cash Budget
Disbursements will be subtracted from Receipts in order to determine
Excess (deficiency) of available cash over disbursements. 47

48. Cash Budget
Assuming that a minimum cash balance of $15,000 must be maintained, $3,000 of financing will be needed in the 2nd quarter. Loans must be paid back the next quarter (if there is sufficient cash) with interest. Assume interest is $100 on the $3,000 borrowed the second quarter. 48

49. Budgeted Balance Sheet
A projection of financial position at the end of the budget period.
Developed from the budgeted balance sheet for the preceding year and the budgets for the current year.
Beginning balances for 2005:
Building and equipment $182,000
Accumulated depreciation $28,800
Common Stock $225,000
Retained earnings $46,480 49

50. Budgeted Balance Sheet
Sources and computations of the amounts in the
Assets section of the Budgeted Balance Sheet are
shown below:
(Ending cash balance shown in cash budget)
(Schedule of cash collections)
(1,000 units x $44 [ production budget])
(1,020 lbs x $4 [direct materials budget])
($182,000 + $10,000 [new truck])
($28,800 + $15,200 MOH budget and $4,000 S&A
budget) 50

51. Budgeted Balance Sheet
(50% of 4th Q purchases of $37,200 on schedule of expected payments)
(Capital - Unchanged from beginning of year)
(2004 balance of $46,480 + net income $47,900) found on Budgeted Income Statement 51

52. Budgeting process Prepare annual budget Identify the limiting factors
Prepare a sales budget
Prepare production budget
Prepare expense budgets of depts.
Prepare capital budgets
Negotiation and approval
Compile master budget
Budgeted Cash flow , P/L, B/S 52

53. Negative responses to budgets
The term ‘budget’ is not always viewed in a positive light by managers because budgets can be perceived as telling them what they can and cannot do. The budget can be seen as a constraint imposed by others on manager’s decision-making powers.
Managers are not always directly involved in budgeting process. Budget preparation can sometimes be a top-down exercise imposed by management. This approach can often inhibit initiative and morale.
There can be a lack of authority over the items line managers are expected to control and have responsibility for.
There is often a conflict between budget managers and personnel who are trying to deliver a quality service and/or product. 53

54. Budgetary control 1. Preparation of budget
2. Communication of the budget details to divisions
3. Comparison of actual results against budget
4. Identification and analysis of variances
5. Taking corrective action to correct/ control the variances 54

55. Materials and Labour Variances55

56. Calculation of Materials and Labour Variances
1. Total direct materials variance
= (Standard price x standard quantity) – (Standard price x
actual quantity)
a. Direct material price variance
= (Standard price x actual quantity) – (Actual price x actual quantity)
b. Direct material usage variance
= (Standard price x standard quantity) – (Standard price x actual quantity)
2. Total direct labour variance
= (Standard rate x standard hours) – (Actual rate x actual hours)
a. Direct labour rate variance
= (Standard rate x actual hours) – (Actual rate x actual hours)
b. Direct labour efficiency variance
= (Standard rate x standard hours) – (Standard rate x actual hours) 56

57. Causes of Variances Causes of variances in salaries & wages
Poor estimate of the rate of pay.
Having to use a higher grade of labor than budgeted for; this could be due to an inability to recruit staff at the budgeted rate.
The need to pay for unplanned overtime due to special circumstances.
There are vacancies in staff positions for a period during the year.
Lower pay awards than anticipated.
The business pays higher national insurance and pension contributions than planned for. 57

58. Causes of Variances Causes of variances in salaries & wages(con’t)
Poorly trained employees providing poor quality goods and services.
The poor supervision by managers.
The low morale of employees. 58

59. Causes of Variances Causes of variances in raw materials and stocks
The price in the original budget was poorly estimated
The impact of nationally or internationally agreed price increases
The use of material which is of a better or worse quality than required in the budget
The business does not take discounts as expected
An ineffective buying policy is operated by the business
Theft of materials and finished goods
Poor quality or deficiencies in materials leading to a high level of scrap
Poor production methods and / or faulty machinery leading to losses 59

60. Causes of Variances
Only variances at a material level should be investigated, (e.g. 5% favorable / adverse variances)
Adverse variances must be investigated and corrective action must be take as they will prove costly
Favorable variances should be investigated as they mean something is not going to plan
Budget holders should not be blamed for costs or variances they cannot control (e.g. Production manager should not be blamed for adverse labor cost variances due to poor materials procured by the procurement dept.)
Unspent budget has to be forfeited 60