BUDGETING

Topic 12
 OUTLINE OF THE TOPIC
• Defining Budgeting
• The importance of Budgeting
• Stages in the Budgeting Process
• Functional Budgets
• Master Budget
• Cash Budget
• Activity Based Budgeting
• Zero - based Budgeting
 DEFINING BUDGETING
• A budget is a financial plan for an organization's outgoing
expenses and incoming revenues for a defined period of
time, usually a year.
• It may also include planned sales volumes and revenues,
resource quantities, costs and expenses, assets, liabilities
and cash flows.
• It is a primary tool in business for planning, tracking, and
controlling spending.
THE IMPORTANCE OF BUDGETING

Planning Coordination Communication

Performance
Motivation Control
Evaluation
 STAGES IN THE BUDGETING PROCESS

Communicating details of budget policy and guidelines.

Determining the limiting factor.

Preparation of the sales budget.

Initial preparation of various budgets.

Negotiation of budgets with superiors.

Coordination and review of budgets.

Final acceptance of budgets.

Ongoing review of budgets.

 FUNCTIONAL BUDGETS

Selling and
Factory
Sales administratio
overhead
n

Production Direct labor Cash

Direct Direct
materials materials Master
usage purchase
 QUESTION 1
• The Mailin Company manufactures two products,
known as alpha and sigma. Alpha is produced in
department 1 and sigma in department 2. The
following information is available for 2019. Standard
material and labor costs:
$
Material X 1.80/unit
Material Y 4.00/unit
Direct labor 3.00/hour
 QUESTION 1 (CONT.)

• Overhead is recovered on a direct labor hour basis.

• The standard material and labor usage for each
product is as follows:
Model alpha Model sigma
Material X 10 units 8 units
Material Y 5 units 9 units
Direct labor 10 hours 15 hours
• The statement of financial position for the previous
year ending 2018 was as follows:
 $ $

NON-CURRENT ASSETS:
Land 42,500
Buildings and equipment (323,000 – 259,250
63,750)
301,750
CURRENT ASSETS:
Inventory: Finished goods 24,769
Raw materials 47,300
Trade receivables 72,250
Cash 8,500 152,819
TOTAL ASSETS 454,569

EQUITY AND LIABILITIES

EQUITY:
300,000 ordinary shares of $1 each 300,000
Reserves 92,369 392,369
CURRENT LIABILITIES:
Trade payables 62,200
454,569
 QUESTION 1 (CONT.)
• Other relevant data is as follows for the year 2019 :
Finished Product
Model alpha Model sigma
Forecast sales (units) 8,500 1,600
Selling price per unit $100 $140
Ending inventory required 1,870 90
(units) 170 85
Beginning inventory (units)
Direct Material
Material X Material Y
Beginning inventory (units) 8,500 8,000
Ending inventory required 10,200 1,700
(units)
 QUESTION 1 (CONT.)

Department Department 2
1
($) ($)

Budgeted variable overhead rates

(per direct labor hour):
Indirect materials 0.30 0.20
Indirect labor 0.30 0.30
Power (variable portion) 0.15 0.10
Maintenance (variable portion) 0.05 0.10
Budgeted fixed overheads:
Depreciation 25,000 20,000
Supervision 25,000 10,000
Power (fixed portion) 10,000 500
Maintenance (fixed portion) 11,400 799
 QUESTION 1 (CONT.)
$

Estimated non-manufacturing overheads:

Stationery etc. (Administration) 1,000
Salaries :Sales 18,500
Office 7,000
Commissions 15,000
Car expenses (Sales) 5,500
Advertising 20,000
Miscellaneous (Office) 2,000

69,000
 QUESTION 3
• Budgeted cash flows are as follows:
Quarter 1 2 3 4
($) ($) ($) ($)
Receipts from 250,00 300,00 280,00 246,25
customers 0 0 0 0
Payments:
Materials 100,00 120,00 110,00 136,99
Payments for wages 0 0 0 6
Other costs and 100,00 110,00 120,00 161,54
expenses 0 0 0 7
30,000 25,000 18,004 3,409
 REQUIRED:
Prepare the following budgets for the year 2019:
1. Sales budget
2. Production budget
3. Direct materials usage budget
4. Direct materials purchase budget
5. Direct labor budget
6. Factory overhead budget
7. Selling and administration budget
8. Cash budget
9. Master Budget
 SALES BUDGET
• The sales budget shows the quantities of each
product that the company plans to sell and the
intended selling price.
• It is based upon the forecast demand for the goods
which is in turn based upon market research,
salesmen’s reports and other trade information
sources.
• It can be expressed in sales volumes (units) or
value.
• Its outline can be as follows:

Month Quantity Price Revenue

(units) ($) ($)
e.g. Jan 20 5 100
 PRODUCTION BUDGET
• It is the budget for the production of finished
goods.
• This budget is expressed in quantities only and is
the responsibility of the production manager. The
objective is to ensure that production is sufficient
to meet sales demand and that economic stock
levels are maintained. e.g. May
Units to be sold 600
Budgeted closing inventory 950
Total units required for sales and stocks 1,550
Budgeted opening inventory (800)
Units to be produced 750
 DIRECT MATERIALS
USAGE BUDGET
• The direct materials usage budget shows estimates
of the materials which are required to meet the
production budget.

Month Production RM/unit Total

(units) (units) (units)
e.g. Feb 1,000 10 10,000
DIRECT MATERIALS PURCHASE BUDGET
• The direct materials purchase budget sets the
quantities of raw materials to meet the production
requirements. The objective is to purchase these
materials at the right time at the planned
purchase price. In addition, it is necessary to take
into account the planned raw material stock levels.

Material X
Material required (DM Usage Budget) 1000
Budgeted closing inventory 200
1,200
Budgeted opening inventory 500
Units to be purchased 7000
Planned unit purchase price $1.00

Total purchases
 DIRECT LABOR BUDGET
• The direct labor budget sets the estimates of the
departments' labor hours required to meet the
planned production.
e.g. July
Budgeted production (units) 1,000
Hours per unit 10
Total budgeted hours 10,000
Budgeted wage rate per 10
hour
Total wages 100,000
 THE FACTORY
OVERHEAD BUDGET
• The factory overhead budget reflects the total of the
overhead that will be incurred depending on the
behavior of the costs of the individual overhead
items in relation to the anticipated level
e.g. August $
Production overheads 1,000
THE SELLING AND ADMINISTRATION
BUDGETS

• The selling and administration budgets reflects the

total of the selling and administration costs that will
be incurred .
e.g. August $
Selling and Admin 2,000
 CASH BUDGET

• The objective of the cash budget is to ensure that

sufficient cash is available at all times to meet the
level of operations that are outlined in the various
budgets.
e.g. August $
Receipts (details) 2,000
Payments (details) (1,000)
Net receipts/ (payments) 1,000
Balance b/f 500
Balance c/f 1,500
 MASTER BUDGET

• When all the budgets have been prepared, the

budgeted profit and loss account and statement of
financial position provide the overall picture of the
planned performance for the budget period.
• They are referred to as the Master Budget.
 QUESTION 2
• A redundant manager who received compensation of
$80 000 decides to commence business on 4
January, manufacturing a product for which he knows
there is a ready market.
• He intends to employ some of his former workers
who were also made redundant but they will not all
commence on 4 January.
• Suitable premises have been found to rent and
second-hand machinery costing $60 000 has been
bought out of the $80 000.
• This machinery has an estimated life of five years
from January and no residual value.
 QUESTION 2 (CONT.)
Additional Information:
• Production will begin on 4 January and 25% of the
following month’s sales will be manufactured in
January. Each month thereafter the production will
consist of 75% of the current month’s sales and 25%
of the following month’s sales.
 QUESTION 3 (CONT.)
• The marketing director suggested that with an
appropriate increase in advertising expenditure sales
could be increased by 20% and a profit on turnover of
15% obtained. It is estimated that in this circumstance
fixed production overhead would increase by US$40,000
and marketing overhead by US$25,000. What additional
expenditure on advertising would be made to achieve
these results?
• The chairman has received an approach from a
department store to supply on a long-term contract
20,000 units per annum at a special discount. Existing
sales would not be affected and fixed production
overhead would be increased by US$50,000 per annum.
How much special discount could be given if by accepting
the contract the profit of the company were to be
increased to US$675,000 per annum?
 REQUIRED
• Compile a forecast profit statement for the year for
each of the proposals given and comment briefly on
each. (25 marks)
 ACTIVITY BASED BUDGETING

• Activity based budgeting is a budgeting method in

which budgets are prepared using
Activity Based Costing after considering the overhead
costs. In simple words, activity based budgeting is
management accounting tool which does not consider
the past year’s budget to arrive at current year’s
budget.
• Instead, the activities that incur the cost are deeply
analyzed and researched. Based on the outcome of
the study, the resources are allocated to an activity.
• This method of budgeting is based on an activity
framework. It uses cost driver data in the budget
setting and variance feedback processes.
 EXAMPLE

• Assume that there are two different setup stages to

make a cell phone: machining and assembling. A
managerial accountant would look at the total
amount of cell phones that need to be produced, the
number of cell phones in each batch, the setup time
for both machining and assembling, as well as the
hourly rate of each machinists and assemblers.
• By looking at all of these different activities, the
managerial accountant could come up with
efficiencies in the production process that would save
the company money.
 NEED OF ACTIVITY BASED BUDGETING

• Activity based budgeting is carried out to bring

efficiency in the activities of an organization.
• Budgets are prepared after justifying the
cost drivers. Thus, activity based budgeting is
activity oriented and not function oriented.
•
 ADVANTAGES OF ACTIVITY
BASED BUDGETING

Competitive Business as
Evaluation
edge a unit

Elimination
Improves
of
relationship
bottlenecks
 DISADVANTAGES OF
ACTIVITY BASED BUDGETING

Requires
Resource
understandin Complex
consumption
g

Costs
Short term
involved
 ZERO BUDGETING
• A budgeting process that allocates funding based on program
efficiency and necessity rather than budget history.
• As opposed to traditional budgeting, no item
is automatically included in the next budget.
• In ZBB, budgeters review every program and expenditure at the
beginning of each budget cycle and must justify each line item
in order to receive funding. Budgeters can apply ZBB to any
type of cost: capital expenditures; operating expenses; sales,
general, and administrative costs; marketing costs; variable
distribution; or cost of goods sold.
• When successful, ZBB produces radical savings and liberates
organizations from entrenched departments and methodologies.
• When unsuccessful, the costs to an organization can be
considerable.
 DEFINING ZBB
Budgets are not
connected
to prior year
spending

Budgets are tied

to specific
ZB Spending increases
or cuts are not
simply spread

B
activities and evenly across
levels of service budgets

Funding is targeted
more to activities that
align with the
strategy
 ADVANTAGES OF ZBB
• Resulting budget is well justified and aligned to
strategy
• Catalyzes broader collaboration across the
organization
• Supports cost reduction by avoiding automatic
budget increases, often resulting in savings
• Improves operational efficiency by rigorous
challenging of assumptions
 DISADVANTAGES OF
ZBB
• Costly, complex, and time consuming as budget is rebuilt
from scratch annually, whereas simpler and faster
traditional budgeting requires justification only for
incremental changes
• May be cost-prohibitive for organizations with limited
funding
• Risky when potential savings are uncertain
• Execution challenged by budget cycle timing constraints
• Typically requires specialized training or personnel to
accomplish, and requires more resources in general
• May be disruptive to the organization’s operations •
Could harm organizational culture or brand