Chapter 3

Information for budgeting, planning and control purposes

Objectives and concepts of budgetary systems
Budget is a plan quantified in monetary terms prepared and approved prior to a defined period of time
 is expressed in monetary as well as non monetary terms. E.g units of products.
is a formal statement of the financial resources set aside for carrying out specific activities
in a given period of time.
Characteristics of a budget
 A good budget is characterized by the following:
 Standards.
 Flexibility
 Feedback
 Analysis of costs and revenues
The main objectives of budget are as follows:
 Planning
 Provide motivational impetus
 Controlling
There are four types of business budgeting methods:
A. Incremental budgeting
 is a budget that is prepared by taking the current period’s budget or actual
performance and using it as a base and then adjusting it by incremental amounts.
B. Activity- based budgeting:
is a budgeting system in which you record and analyze every activity that creates
a cost to find areas for improving.
It's an in-depth analysis of expenses and how they may affect a company's
performance.
C. Value proposition budgeting
A value proposition is a simple statement that clearly communicates the product
or service benefit you promise to deliver to your customers.
 D. Zero Based budget:
The zero based in that each cost is not necessarily scrutinized and justified, but simply
adjusted for expectations in the coming period.
Budgetary control and responsibility centers
Budgetary control is a control technique where by actual results are compared with
budgets.
These enable managers to monitor organizational functions.
A responsibility center can be defined as any functional unit headed by a manager who is
responsible for the activities of that unit.
There are four types of responsibility centers: Revenue centers, Expense centers, Profit
centers, Investment centers
 Advantages of budgeting and budgetary control
 Promotes coordination and communication.
 Clearly defines areas of responsibility.
 Motivates employees by participating in the setting of budgets.
 Improves the allocation of scarce resources.

1. Monitoring and controlling performance and Variance Analysis

A variance is the difference between an actual result and an expected result.
The process by which the total difference between standard and actual results analyzed is
known as variance analysis.
When actual results are better than the expected results, we have a favorable variance (F).
Variable cost variances
1. Direct material variances: Direct material variance divided into two sub-variances.
a. The direct material price variance: This is the difference between what the actual
quantity of material used did cost and what it should have cost.
b. The direct material usage variance: This is the difference between how much material
should have been used for the number of units actually produced and how much material
was used, valued at standard cost.
2. Direct labour total variance
a. Direct labour rate variance: This is the difference between what the actual number of
hours worked should have cost and what it did cost.
b. The direct labour efficiency variance: is the difference between how many hours should
have been worked for the number of units actually produced and how many hours were
worked, valued at the standard rate per hour.
 3. Variable production overhead total variances
•The variable production overhead total variance is the difference between what the output
should have cost and what it did cost, in terms of variable production overhead.

The variable production overhead expenditure variance: This is the difference between
what the variable production overhead did cost and what it should have cost.
The variable production overhead efficiency variance: This is the same as the direct
labour efficiency variance in hours, valued at the variable production overhead rate per
hour.

4. Fixed production overhead variances

•The total fixed production variance is an attempt to explain the under- or over-absorbed
fixed production overhead.
overhead absorption rate = Budgeted fixed production overhead
Budgeted level of activity
 Selling price variance
•The selling price variance is a measure of the effect on expected profit of a different
selling price to standard selling price. It is calculated as the difference between what the
sales revenue should have been for the actual quantity sold, and what it was.
•Sales volume variance: The sales volume variance is the difference between the actual
units sold and the budgeted quantity, valued at the standard profit per unit.

A budget expressed in relation to:

Period
Behavior
Functions
 Fixed and Flexible budgets
1. Fixed budgets
A fixed budget is a budget which is used unaltered during the budget period. It is
prepared for a particular activity level and it does not change with actual activity level
being higher or lower than budgeted activity level. In other words, this budget does
not highlight the ‘activity variance’,.

Following are the disadvantages of fixed budget:

 It is misleading.
 It is inadequate for control purposes.
 It violates logic.
1. Flexible Budget (Dynamic Budget)
•A flexible budget is a budget which, by recognizing different cost behavior patterns, is designed to change as
volume of output changes. It is designed to furnish budgeted cost at any level of activity actually attained. Is
known as variable or sliding scale budget.
•Flexible budgeting helps both in profit planning and operating cost control. Is sometimes called a variable
budget. Is a budget that can easily be adjusted for differences in the level of activity.
Features of Flexible Budget
Flexible budgets have several desirable characteristics. They:
i. Cover a range of activity
ii. Are dynamic
iii. Facilitate performance measurement.
•Flexible Budgeting Process
The following steps are needed to develop a flexible budget.

i. Determine the range of activity the budget should cover

ii. Determine the cost behavior pattern for each cost included in the budget.
iii. Select the activity levels for which budgets will be prepared.
iv. Prepared a flexible budget using the cost behavior data and the selected activity level.
Example (2): Evergreen Company is planning to use a flexible budgeting system to plan and
control its operations. Evergreen made the following cost estimates for budgeting purposes:
Budget Formula Per Unit
Sales Br. 31.00
Variable Costs
* Manufacturing Br. 21.00
* Selling 0.60
* Administrative 0.20
Total Variable Costs Br. 21.80
Contribution Margin Br. 9.20
Budget Formula Per Month
Fixed Costs
• Manufacturing Br. 37,000
* Selling and administrative 33,000
Total fixed costs Br. 70,000
Instruction: Prepared a flexible budget for the next month using 7,000, 8,000, and 9,000 units as activity level.
Evergreen Company’s cost functions or flexible budget formulas are believed to be valid within the range of
7,000 to 9,000 units. At what level of activity does the company breakeven?
Exhibit 2.2 Evergreen Co. Flexible Budget
Flexible Budgets for Various Activity Levels
7,000 units 8,000 units 9,000 units
Sales Br. 217,000 Br. 248,000 Br. 279,000
Variable Costs
* Manufacturing Br. 147,000 Br. 168,000 Br. 189,000
* Selling 4,200 4,800 5,400
* Administrative 1,400 1,600 1,800
Total Variable Costs Br. 152,600 Br. 174,400 Br. 196,200
Contribution margin Br. 64,400 Br. 73,600 Br. 82,800
Fixed costs
* Manufacturing Br. 37,000 Br. 37,000 Br. 37,000
*Selling and administrat 33,000 33,000 33,000
Total fixed costs Br. 70,000 Br. 70,000 Br. 70,000
Operating income (loss) Br. (5,600) Br. 3,600 B. 12,800
BEP (in units) = Total fixed costs /Unit Contribution Margin
= Br.70, 000 /31-21.8
= 7609 units (approximation) BEP (in birrs)
CM-ratio = contribution margin per unit/unit selling price
9.2/31= 0.29 = 29%
Master budgets
The master budget is the total budget package for an organization. It is the end product
that consists of all the individual budgets for each part of the organization aggregated into
one overall budget for the entire organization.
Components of master budget
There are two major components of master budget. Such are operating budget and the
financial budget.
1. Operating budget: - It focuses on income statement and supporting schedules. It is also
called profit plan. However, such budget may show a budgeted loss, or can be used to
budget expenses in an organization or agency with no sales revenues.
2. Financial budget: - It focuses on the effects that the operating budget and other plans will
have on cash. The usual master budget for a non-manufacturing company has the following
components.
1. Operating budget includes: 2. Financial budget include:
a. Sales budget a. Capital budget
b. Purchases budget b. Cash budget
c. Cost of goods sold budget c. Budgeted balance sheets
d. Operating expense budget d. Budgeted statement of cash flows
The operating budget is composed of the income statement elements.

Sales Budget: The sales budget is the first budget to be prepared. It is usually the most
important budget because so many other budgets are directly related to sales. Inventory
budgets, purchases budgets, personnel budgets, marketing budgets, administrative budgets,
and other budget areas are all affected significantly by the amount of revenue that is
expected from sales.
• The sales budget is usually based on a sales forecast. A sales forecast is a prediction of
sales under a given conditions. Important factors considered by sales forecasters include:
 Past patterns of sales
 General economic conditions
 Competitive actions
 Changes in the firm’s prices
 Changes in product mix
 Advertising and sales promotion plans
• Purchases Budget: After sales are budgeted, prepare the purchases budget. The total
merchandise needed will be the sum of the desired ending inventory plus the amount
needed to fulfill budgeted sales demand.
• These purchases are computed as follows:
Budgeted Desired Cost of Beginning
Purchases = Ending inventory + Goods Sold - Inventory
• Budgeted cost of goods sold: For a manufacturing firm, cost of goods sold is the
production cost of products that are sold. The cost of goods sold budget comes directly
from merchandise inventory and the merchandise purchases budget.
•Operating Expense Budget: The budgeting of operating expenses depends on various
factors. Month – to – month fluctuation in sales volume and other cost-drivers activities
directly influence many operating expenses.
Examples sales commissions and many delivery expenses.
•Budgeted Income Statement: The budgeted income statement is the combination of all
of the preceding budgets. This budget shows the expected revenues and expenses from
operations during the budget period.
 2. Financial Budget
•The second major part of the master budget is the financial budget, which consists of the
capital budget, cash budget, ending balance sheet and the statement of changes in
financial position. There are some differences in operating budgets
Capital expenditure budget: The capital expenditure budget or capital budget describes
the capital investment plans for an organization for the budget period.
Cash budget: is a statement of planned cash receipts and disbursements. The cash budget
is composed of four major sections:
(i) The receipts section: It consists of a listing of all of the cash inflows, except for
financing, expected during the budget period. Generally, the major source of receipts
will be from sales.
(ii) The disbursement section: It consists of all cash payments that are planned for the
budget period. These payments will include inventory purchases, wages and salary
payments and so on. In addition, other cash disbursements such as equipment
purchases, dividends, and other cash withdrawals by owners are listed.
(iii) The cash excess or deficiency section: The cash excess or deficiency section is
computed as follows:
Cash balance, beginning xxx
Add: receipts xxx
Total cash available before financing xxx
Less: disbursements xxx
Excess (deficiency) of cash available over disbursements xxx
(iv)The financing section: This section provides a detail account of the borrowing and
repayments projected to take place during the budget period. Includes a detail of
interest payments.
Budgeted Balance Sheet: is called the budgeted statement of financial position, is derived
from the budgeted balance sheet at the beginning of the budget period and the expected
changes in the account balance reflected in the operating budget, capital budget, and
cash budget.

Budgeted Statement of Changes in Financial Position: The final element of the master
budget package is the statement of changes in financial position. This statement is usually
prepared from data in the budgeted income statement and changes between the
estimated balance sheet at the beginning of the budget period and the budgeted balance
sheet at the end of the budget period.
Preparing the Master Budget

The master budget is a network consisting of many separate but interdependent budgets.