CHAPTER THREE

INFORMATION FOR BUDGETING, PLANNING, AND CONTROL PURPOSES

3.1. OBJECTIVES AND CONCEPTS OF BUDGETARY SYSTEMS
What is a budget?
A budget is a plan expressed in quantitative, usually monetary terms, covering a specific period
of time, usually one year. In other word, a budget is a systematic plan for the utilization of
manpower and material resources. In a business organization a budget represents an estimate of
future costs and revenues.
3.2. THE MAIN CHARACTERISTICS OF A BUDGET
 It is prepared in advance and is derived from a long-term strategy of the
organization.
 It relates to future period for which objectives or goals have already been laid
down.
 It is expressed in quantitative form, physical or monetary units, or both.
3.3. OBJECTIVE OF BUDGETARY SYSTEM
3.4. BUDGETARY CONTROL
Budgetary control is a system for monitoring an organization's process in monetary terms
No system of planning can be successful without having an effective and efficient system of
control. The exercise of control in the organization with the help of budgets is known as
budgetary control. The process of budgetary control includes:
 Preparation of various budgets
 Continues comparison of actual performance with budgetary performance, and
 Revision of budgets in the light of changed circumstances.
A system of budgetary control should not be rigid. It should have enough scope for flexibility to
provide for individual initiatives and derive. Budgetary control is an important device for making
the organization more efficient on all fronts. It is an important tool for controlling costs and
achieving the overall objectives.
3.3. OBJECTIVE OF BUDGETARY CONTROL
The primary objective of budgetary control is to help the management in systematic planning and
in controlling the operations of the enterprise. The primary objective can be met only if there is
proper communication and coordination amongst different within the organization.
3.4. PRINCIPAL BUDGET FACTOR OR KEY FACTOR
It is also termed as budget limiting factor, i.e. the factor that can limits production and sales of a
product. normally a sale is the key factor or principal budget factor but other factors like
production purchase, and skilled labor may also be the key factors. For example, a company has
production capacity to produce 30,000 tones per annum but if the sales forecast tells that the
market can absorb only 20,000 units, there is no point in producing 30,000 units. Thus, the sale is
the key factor in this case. On the other hand, if the company has capacity to produce 30,000
units and the market has the capacity to absorb the entire production which means that sales is
not the key factor but if raw material is available in limited quantity so that only 25,000 units can
be produced, the raw material will become the key factor. The key factor puts restrictions on the
other functions and hence it must be considered carefully in advance. So, continuous assessment
of the business situation becomes necessary. In all conditions the key factor is the starting point
in the process of preparation of budgets. A typical list of some of the key factors is given below.
Sales: Consumer demand, shortage of sales staff, inadequate advertising
Material: Availability of supply, restrictions on import
Labor: Shortage of labor
Plant: Availability of capacity, bottlenecks in key processes
Management: Lack of capital, pricing policy, shortage of efficient executives, lack of
know- how, faulty design of the product etc.
3.5. CLASSIFICATION OF BUDGET
Budget can be classified into different categories on the basis of time, function, capacity
utilization /or flexibility. So, budgets can be classified as per the following basis.
 On the basis of Area of Operation /or activity
A. Functional /operational Budgets
B. financial budget
 On the basis of flexibility ( Capacity Utilization)
A. Fixed Budget
B. Flexible Budgets
 On the basis of Time
A. Short Term
 B. Medium Term
C. Long Term
1. Activity Perspective
i. Operating Budgets: These are budgets that reflect day-to-day activities or operations of
an organization. This category deals with items of manufacturing, trading and profit and
loss accounts like material purchases, labor cost, production and overhead, sales,
purchases, ending inventory, opening inventory, etc, budgets. It also deals with revenue
or incomes budgets and expenses or expenditure budgets. Operating budget is
synonymous with recurrent expenditure budget of the government financial year.
ii. Financial Budget: This relates to financing of assets and generally indicates cash inflow
and outflow. Capital budgeting is part of financial budget. This category is the budget to
be prepared on the funds to be generating through different sources for the financing of
various projects. The budget would indicate ownership of assets and insurance of
liabilities and, so it gives the information which would enable a budgeted balance sheet
to be prepared. Capital budgeting, which is part of financial budget, is synonymous with
capital expenditure budget of the government financial year.
2. Classification of Budgets flexibility or Capacity Utilization perspective
i. Fixed Budgets: When a budget is prepared by assuming a fixed percentage of capacity
utilization, it is called as a fixed budget. For example, a firm may decide to operate at 90%
of its total capacity and prepare a budget showing the projected profit or loss at that
capacity. This budget is defined by The Institute of Cost and Management Accountants
[U.K.] as ‘the budget which is designed to remain unchanged irrespective of the level of
activity actually attained. It is based on a single level of activity.’ For preparation of this
budget, sales forecast will have to be prepared along with the cost estimates. Cost
estimates can be prepared by segregating the costs according to their behavior i.e. fixed
and variable. Cost predictions should be made element wise and the projected profit or
loss can be worked out by deducting the costs from the sales revenue. Actually in practice,
fixed budgets are prepared very rarely. The main reason is that the actual output differs
from the budgeted output significantly. Thus if the budget is prepared on the assumption
of producing 50,000 units and actually the number of units produced are 40, 000, the
comparison of actual results with the budgeted ones will be unfair and misleading. The
 budget may reveal the difference between the budgeted costs and actual costs but the
reasons for the deviations may not be pointed out. A fixed budget may be prepared when
the budgeted output and actual output are quite close and not much deviation exists
between the two. In such cases, maximum control can be exercised between the budgeted
performance and actual performance.
ii. Flexible Budgets: A flexible budget is a budget that is prepared for different levels of
capacity utilization. It can be called as a series of fixed budgets prepared for different
levels of activity. For example, a budget can be prepared for capacity utilization levels of
50%, 60%, 70%, 80%, 90% and 100%. The basic principle of flexible budget is that if a
budget is prepared for showing the results at say, 15, 000 units and the actual production is
only 12, 000 units, the comparison between the expenditures, budgeted and actual will not
be fair as the budget was prepared for 15, 000 units. Therefore a flexible budget is
developed for a relevant range of production from 12, 000 units to 15,000 units. Thus even
if the actual production is 12, 000 units, the results will be comparable with the budgeted
performance of 12, 000 units. Even if the production slips to 8, 000 units, the manager has
a tool that can be used to determine budgeted cost at 9, 000 units of output. The flexible
budget thus, provides a reliable basis for comparisons because it is automatically geared to
changes in production activity. Thus a flexible budget covers a range of activity, it is
flexible i.e. easy to change with variation in production levels and it facilitates
performance measurement and evaluation.
While preparing flexible budget, it is necessary to study the behavior of costs and divide them in
fixed, variable and semi variable. After doing this, the costs can be estimated for a given level of
activity.
It is also necessary to plan the range of activity. A firm may decide to develop flexible budget for
activity level starting from 50% to 100% with an interval of 10% in between. It is necessary to
estimate the costs and associate them with the chosen level of activity.

Finally the profit or loss at different levels of activity will be computed by comparing the costs
with the revenues.
3. Classification of Budgets According to Time: According to this classification, budgets are
divided in the following categories.
i. Short Term Budget: Any budget that is prepared for a period up to one year is known as
Short Term Budget. Functional budgets are normally prepared for a period of one year and
then it is broken down month wise.
ii. Medium Term Budget: Budget prepared for a period 1-3 years is Medium Term Budget.
Budgets like Capital Expenditure, Manpower Planning are prepared for medium term.
iii. Long Term Budgets: Any budget exceeding 3 years is known as Long Term Budgets.
Master Budget is normally prepared for long term. In the modern days due to uncertainty,
very few budgets are prepared for long term.
The Master Budget: an overall plan
Manufacturing operations require a series of budgets that are linked together in a master budget. Master
budget is a set of interconnected budgets of the following major parts of the master budget.
Budgeted income statement/operational Budgeted balance sheet
Budget Financial budget
Sales budget Cash budget
Cost of goods sold budget Capital expenditure budget
Production budget
Direct material purchases budget
Direct labor cost budget
Factory overhead cost budget
Selling and administrative expenses budget
A budget is a plan of future financial transactions. A master budget serves as planning and control tool to
the management since they can plan the business activities during the period on the basis of master
budget. At the end of each period, actual results can be compared with the master budget and necessary
control actions can be taken.
Figure 1.1 shows the relationship among the income statement budgets. The budget process begins by
estimating sales. The sales information is then provided to the various units for estimating the production
and selling and administrative expense budgets. The production budgets are used to prepare the direct
materials purchases, direct labor cost, and factory overhead cost budgets. These three budgets are used to
develop the cost of goods sold budget.
 Sales
budget

Production
budget

Direct materials Direct labor Factory

purchases budget budget overhead
budget
Selling & Cost of goods
admin. sold budget
Expenses
budget Budgeted
income
statement
budget
Figure 1.1
Once these budgets and the selling and administrative expenses budget have been completed the
budget income statement can be prepared as well illustrate in the following section.
After the budgeted income statement has been developed, the budgeted balance sheet can be
prepared. Two major budgets comprising the budgeted balance sheet are the cash budget and the
capital expenditures budget, we illustrate later.
Note that all of the above component budgets may not be included in the master budget of every
business. Some of these such as production budget and cost of goods manufactured budget are
not need by a non-manufacturing business.
3.6. Order of components of master budget
As we said earlier, the components of master budget are interconnected, which means that
numbers from one component budget flow to another one. For example sales budget numbers are
used in schedule of cash receipts from customers and unless the sales budget is prepared we are
unable to prepare schedule of receipts from customers because of lack of information. This
means that components of master budget must be prepared in a specific order. We have ordered
the above list in such a way that the necessary information needed by any component budget is
provided by a preceding component.
Income statement /operational budget
In the following sections, we will illustrate the major elements of the income statement budget.
We will use a small manufacturing business.
A. Sales Budget
Sales budget is the first and basic component of master budget. It is usually the most important
budget because so many other budgets are directly related to sales and are largely derived from
the sales budget. Inventory budget, purchases budget, labor budget, marketing budget,
administrative budgets, the schedule of receipts from customers, payments to customers and
other budgets are all affected significantly by amount of revenue that is expected from sales.
Sales budgets are influenced by a wide variety of factors that are
- expected future sales, - potential market,
- unfilled sales orders on hand, - seasonal fluctuation,
- past patterns of sales, - Governmental controls, rules, and
- general economic conditions, regulation related to the industry,
- competitor actions, - availability of materials or supplies
- plant capacity,
Due to the fact that many components of master budget rely on sales budget, the estimated sales
volume and price must be forecasted with sufficient care and only reliable forecast techniques
should be employed.
FORMAT
The sales budget format will be simple as shown below.
Units to be sold X selling price (SP) per unit = $x
Illustration #01
The following data are available for developing Gibe Furniture Company’s 2012 master budget.
A. Revenue expected from sales of tables for 2012 are:
Selling Price Br. 392/table
Unit Sales 52,000 tables
B. Inventory information in physical units for 2012.
Beginning Inventory Target Ending Inventory
Direct materials:
Material A 20,000 board feet 18,000 board feet
Material B 25,000 board feet 22,000 board feet
Finished goods:
Tables 5,000 tables 3,000 tables
C. Each table has the following product specifications:
Direct Materials:
Material A 9 board feet/table
Material B 10 board feet/table
Direct Labor:
Laminating Labor 0.25Hrs/table
Machine Labor 3.75 Hrs/table
D. Costs per unit expected for 2012.
2012
Material A/ board feet Br. 4.00
Material B/ board feet 6.00
Laminating labor/ Hr. 25.00
Machine labor/ Hr. 30.00
E. Other budgeted costs and amounts for 2012 are:
Variable Non-manufacturing Costs 13.5% of sales
Fixed Non-manufacturing Costs Br. 1,400,000
Variable MOH costs Br. 9.50/DL Hr.
Fixed MOH costs Br. 1,600,000
F. The beginning and ending inventory cost is Br.275/table and Br.287.81/table in 2011.
Required: Prepare the following budgets for Gibe Furniture Company for 2012
1) Sales Budget
2) Production Budget
3) Direct Materials Usage Budget and Direct Materials Purchase Budget
4) Direct Labor Budget
5) MOH Budget
6) Cost of goods manufactured Budget
7) Cost of Goods Sold Budget
 8) Operating Expenses Budget
9) Budgeted Income Statement
10) Ending inventory budget
Solution for the illustration Question
A.
Gibe Company
Sales budget
For the year ended 2012
Unit sales volume 52,000 table
X unit selling price Birr 392/table
Sales budget Birr 20,384,000
B. Production Budget
Production budget is a schedule showing planned production in units which must be made by a
manufacturer during a specific period to meet the expected demand for sales and the planned
finished goods inventory. The required production is determined by subtracting the beginning
finished goods inventory from the sum of expected sales and planned/target ending inventory of
the period. The desired ending inventory in units for each period is usually a predetermined
percentage of budgeted unit sales for the following period. The production budget is typically
expressed in terms of physical units rather than in dollars. Thus:
Units To Be Produced = Budgeted Unit Sales + Desired Ending Finished Goods
- Beginning Finished Goods
Production budget is prepared after sales budget since it needs the expected sales units’ figure
which is provided by the sales budget. It is important to note that only a manufacturing business
needs to prepare the production budget.
In a merchandising firm, a merchandise purchases budget would replace the production
budget. The merchandise purchases budget shows the amount of goods to be purchased
from suppliers each period. This can be determined by adding together the budgeted sales
and the desired ending inventory and then subtracting the beginning inventory. As in a
manufacturing firm, the desired ending inventory in units is usually some predetermined
percentage of the unit sales for the following period.
From illustration #1 production budget is
 Gibe company
Production budget
For the year ended 2012
Expected sales in units 52,000 tables
Add: Desired ending inventory of finished goods 3,000 tables
Total Units Required 55,000 tables
Less: Expected Beginning Inventory of finished goods 5,000 tables
Units to be produced 50,000 tables
C. Direct Material Purchases Budget
Direct material purchases budget shows the amount of direct materials that must be purchased
and its cost during a specific period. Direct material purchases budget is a component of master
budget and it is based on the following formula:
Production budget/units to be produced
X Direct Material required per unit
=Direct Material required for production
Add: Desired direct Material ending Inv.
=Total Dm Required
Less: Desired beginning inv.
=Direct Material purchased budget
X Direct material price per unit
=Direct Material purchased budget
However, the direct materials purchased budget is prepared after the total usage of materials in
the production is determined
Gibe company
Direct material purchased budget
For the year ended 2012
Direct Materials
Material A Material B Total
Production budget/units to be produced 50,000 tables 50,000 tables
X Direct Material required per unit 9 board feet 10 board feet
Direct Material required for production 450,000 bf 500,000bf
Add: Desired direct Material ending Inv. 18,000 bf 22,000 bf
Total Dm Required 468,000 bf 522,000bf
Less: Desired beginning inv. 20,000 bf 25,000bf
Direct Material purchased budget 448,000 bf 497,000 bf
X Direct material price per unit Birr 4.00 Birr 6.00
Direct Material purchased budget Br 1,952,000 Br 2,982,000 Birr 4,934,000

D. Direct Labor Budget

Direct labor budget shows the total direct labor cost and number of direct labor hours needed for
production. It helps the management to plan its labor force requirements. Direct labor budget is a
component of master budget. It is prepared after the preparation of production budget because
the budgeted production in units figure provided by the production budget serves as starting
point in direct labor budget.
Following are the calculations involved in the direct labor budget:
Budgeted Production in unit
× Direct Labor Hours Required per Unit
= Budgeted Direct Labor Hours Required
× Direct labor rate per Hour
= Budgeted Direct Labor Cost
Gibe company
Direct labor cost budget
For the year ended 2012
Direct Labor
Laminating Machine Total
Production budget/units to be produce 50,000 tables 50,000 tables
X Direct labor hours required per unit 0.25Hrs 3.75Hrs
Total Direct labor Hrs required for production 12,500 Hrs 187,500Hrs
X Direct labor rate per Hrs 25 30
Direct labor cost budget Br 312,500 Br5,625,000 Br 5,937,500
G. Factory Overhead Budget
The factory overhead budget shows all the planned manufacturing costs which are needed to
produce the budgeted production level of a period, other than direct costs which are already
covered under direct material budget and direct labor budget. The overhead budget is an
operational budget contained in the master budget of a business. It has two sections, one for
variable overhead costs and other for fixed overhead costs.
Total variable overhead may be calculated as the product of estimated variable cost per unit (also
called variable overhead rate) and the budgeted production units (obtained from production
budget). However, most businesses will prefer to prepare a detailed overhead budget showing
individual variable costs such as electricity, fuel, supplies etc. The fixed overhead costs are
calculated as the sum of individual fixed overhead costs for example rent, depreciation, etc.
which are planned for the period.
It is also useful to calculate the expected cash disbursements for factory overhead costs at the end
of overhead budget.
Total Direct labor Hrs required for production
X Variable MOH rate per Hrs
=MOH cost budget
Add: Fixed MOH cost
=Total Manufacturing overhead budget
Gibe company
Manufacturing Overhead cost budget
For the year ended 2012
Direct Labor
Laminating Machine Total
Total Direct labor Hrs required for
production 12,500 Hrs 187,500Hrs
X Variable MOH rate per Hrs Birr 9.5 Birr 9.5
MOH cost budget Br 118,750 Br 1,781,250 Birr 1,900,000
Add: Fixed MOH cost Birr 1,600,000
Total Manufacturing overhead budget Birr 3,500,000
E. Cost of Goods Manufactured Budget
Cost of goods manufactured budget is an operational component of master budget. It is prepared
to calculate the manufacturing costs that are expected to be incurred on budgeted finished goods.
The cost of goods manufactured budget is based on direct material purchases budget, direct labor
cost budget and factory overhead budget.
Direct Material Purchases
+ Direct Material Beginning Inventory
− Direct Material Ending Inventory
= Cost of Direct Material Used in Production
The next step is to calculate the budgeted cost of goods manufactured as follows:
Cost of Direct Material used in Production
+ Direct Labor Cost
+ Factory Overhead Cost
= Manufacturing Cost
+ Beginning Work in Process
− Ending Work in Process
= Cost of Goods Manufactured
Gibe Company
Cost of Goods Manufactured Budget
For the Year Ending 2012
Direct Material Purchases Birr 4,934,000
Add: Beginning Direct Material 230,000
Materials available for use 5,157,000
Less: ending inv. 204,000
Direct Material used/Cost 4,953,000
Add: Direct Labor Cost 5,937,500
Add: Manufacturing Overhead 3,500,000
Total Manufacturing Costs Birr 14,390,500
Add: Beginning Work in Process 0
Less: Ending Work in Process 0
Budgeted Cost of Goods Manufactured Birr 14,390,500

F. Cost of goods sold budget

The direct materials purchases budget, direct labor cost budget and factory overhead budget are
the starting point for preparing the cost of goods sold.
 Budgeted Cost of Goods Manufactured
Add: beginning finished goods
=Goods available for sale
Less: ending inventory
Cost of goods sold budget
Gibe Company

Cost of Goods Sold Budget

For the Year Ending 2012

Budgeted Cost of Goods Manufactured Birr 14,390,500

Add: beginning finished goods 5,000X275= 1,375,000

Goods available for sale Birr 15,765,500

Less: ending inventory 3,000X287.81 863,430

Cost of goods sold budget Birr 14,902,070

G. Selling and Administrative Expense Budget

Selling and administrative expense budget is a schedule of planned operating expenses other than
manufacturing costs. It is a component of master budget and it is prepared by all types of
businesses (i.e. manufacturers, retailers and service providers) before the preparation of budgeted
income statement. Usually it is divided in two sections: the selling expenses and the
administrative expenses.
Both selling expenses and administrative expense may be fixed or variable (see cost behavior).
For example sales commission and freight cost on sales are variable selling expenses where as
sales salaries are fixed selling expenses. Similarly depreciation and rent on office building are
fixed administrative expenses whereas office supplies and utilities expense are variable
administrative expenses.
Different variable selling and administrative expenses vary with different types activities. For
example sales commission vary with number of units sold, entertainment expenses with number
of employees in the organization etc., therefore an accurate selling and administrative expenses
budget can be made by using activity based costing.
Variable non-manufacturing cost
 Add: fixed non-manufacturing cost
Selling and administrative budget
Gibe Company

Selling and administrative Budget

For the Year Ending 2012

Variable non-manufacturing cost 13.5%X20,384,000 Br 2,751,840

Add: fixed non-manufacturing cost 1,400,000

Selling and administrative budget Birr 4,151,840

H. Cash Budget
Cash budget is a financial budget prepared to calculate the budgeted cash inflows and outflows
during a period and the budgeted cash balance at the end of the period. Cash budget helps the
managers to determine any excessive idle cash or cash shortage that is expected during the
period. Such information helps the managers to plan accordingly. For example if any cash
shortage in expected in future, the managers plan to change the credit policy or to borrow money
and if excessive idle cash is expected, they plan to invest it or to use it for the repayment of loan.
All businesses need to maintain a safe level of cash to enable them to carry on business activities.
The managers of a business need to determine that safe level. The cash budget is then prepared
by taking into consideration, that safe level of cash. Thus, if a cash shortage is expected during a
period, a plan is made to borrow cash.
Cash budget is a component of master budget and it is based on the following components of
master budget:
Schedule of expected cash collections
Schedule of expected cash payments
selling and administrative expense budget
Sample Cash Budget:
Jan Feb Mar Apr
A. Receipts $ $ $ $
Sales Income xx xx xx xx
Other incomes xx xx xx xx
 Loan xx - - -
Total Estimated Cash Receipt xx xx xx xx
B. Disbursements
Raw materials purchases xx xx xx xx
Operating expenses xx xx xx xx
Machinery purchases xx - - -
Loan Repayment & Interest - - xx -
Total Estimated Cash payments xx xx xx xx
C. Net Cash Flow (A - B) xx xx xx xx
Add Opening balance xx xx xx xx
Closing Balance xx xx xx xx
The Net cash flow can be positive, negative or zero.
Budgeted Financial Statements: The last components of the master budget consist of the
budgeted income statement and the budgeted statement of financial position.
Budgeted Income Statement
The budgeted income statement is a projected income statement based on the various parts of the
operating budgets. It is a summary of the expected results and shows whether or not profit plans,
as reflected in the budgets, can be realized by bringing together the various revenue and expense
budgets and making it more easier to evaluate the overall operation of the firm for the budget
period.
Gibe company
Income statement budget
For the year ended 2012
Revenue from sales Birr 20,384,000
Less: cost of goods sold 14,902,070
Gross profit Birr 5,481,930
Less: operating Expenses:
Selling and administrative expenses 4,151,840
Income before income tax Birr 1,330,090
Budgeted Balance Sheet
This, also, is to be prepared in the format of a balance sheet, using the available data. Budgeted
balance sheet is to be prepared using the format approved for internal use or the format approved
for external use, depending on the availability of relevant data.
Ending inventory budget
Gibe company
Ending inventory budget
For the year ended 2012
Qty Cost per unit Total
Direct Materials:
Material A 18,000 bf Birr 4.0 72,000
Material B 22,000 bf 6.0 132,000 204,000
Finished goods
3,000 287.81 863,430
Total ending inventory Birr 1,067,430