Budget

Assignment No.2 Use of Various Techniques of Budgeting

B UDGET:

A budget is a plan for the future. Hence, budgets are planning tools, and they are usually prepared prior to the start of the period being budgeted. However, the comparison of the budget to actual results provides valuable information about performance. Therefore, budgets are both planning tools and performance evaluation tools.

Budgets are part of a company's long-range planning system. While some portions of a long-range plan are concerned with the organization in five to ten years, the budget is the short-range portion of the plan. The following figure 1.1 shows that how the budgetary process fits into an overall general framework of planning, decision-making and control.

1. Establish objectives

2. Identify potential courses of action (i.e. strategies)

3. Evaluate alternative strategic options

4. Select alternative courses of action

5. Implement long-term plan in the form of the annual budget

6. Monitor actual results

7. Respond to divergencies from plan

Figure 1.1 The role of long-term planning and budgeting within the planning, decision-making and control process

A budget is a quantitative plan for the future that assists the organization in coordinating activities. All large organizations prepare budgets. Many organizations prepare detailed budgets that look one year ahead, and budgets that look further into the future that contain relatively less detail and more general strategic direction.

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Annual budgeting process

Long-term planning process


M ULTIPLE F UNCTIONS/ U SES OF B UDGETS:

Budgets serve a number of useful purposes. They include:1. planning annual operations;2. coordinating the activities of the various parts of the organization and

ensuring that the parts are in harmony with each other;3. communicating plans to the various responsibility centre managers;4. motivating managers to strive to achieve the organizational goals;5. controlling activities;6. evaluating the performance of managers.

Planning

The budgeting process ensures that managers do plan for future operations, and that they consider how conditions in the next year might change and what steps they should take now to respond to these changed conditions. This process encourages managers to anticipate problems before they arise, and hasty decisions that are made on the spur of the moment, based on expediency rather than reasoned judgment will be minimized.

Coordination

The budget serves as a vehicle through which the actions of the different parts of an organization can be brought together and reconciled into a common plan. Without any guidance, managers may each make their own decisions, believing that they are working in the best interests of the organization.

Communication

Through the budget, top management communicates its expectations to lower level management, so that all members of the organization may understand these expectations and can coordinate their activities to attain them.

MotivationThe budget can be a useful device for influencing managerial behavior and motivating managers to perform in line with the organizational objectives. A

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budget provides a standard that under certain circumstances, a manager may be motivated to strive to achieve.

Control

A budget assists managers in managing and controlling the activities for which they are responsible. By comparing the actual results with the budgeted amounts for different categories of expenses, managers can ascertain which costs do not conform to the original plan and thus require their attention.

S TAGES IN B UDGETING P ROCESS:

The important stages are as follows:

1. communicating details of budget policy and guidelines to those people responsible for the preparation of budgets;

2. determining the factor that restricts output;3. preparation of the sales budget;4. initial preparation of various budgets;5. negotiation of budgets with superiors;6. coordination and review of budgets;7. final acceptance of budgets;8. ongoing review of budgets.

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USES OF VARIOUS BUDGETING

TECHNIQUES

M ASTER B UDGETING

The most common budgeting technique is to create a master budget which is the overall collection of budgets for the operation of the organization. It consists of the budgets for sales, manufacturing costs (materials, labor, and overhead) or merchandise purchases, selling expenses, and general and administrative expenses. These budgets are fixed, static or expected budgets.

Sales budget

The sales budget is the starting point in putting together a comprehensive budget for a business. It includes the number of units to be sold and the selling price per unit. It is important to agree to the sales budget first because many other budgets are based on this data. Although its components are simple, getting a management team to agree on the number of units to be sold and the selling price per unit, the two items needed to prepare the budget, is often difficult and time- consuming. The Pickup Trucks Company, which makes trucks, has just completed its budgeting process for next year. Total expected sales are 100,000 trucks at a price of Rs.15.00 each. Its sales budget has been prepared on a quarterly basis as follows:

The Pickup Trucks Company Sales Budget For the Year Ended December 31, 20X1

Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total

Units 15,000 17,000 28,000 40,000 100,000

Selling Price Rs.15 Rs.15 Rs.15 Rs.15 Rs.15

Total Sales Rs.225,000 Rs.255,000 Rs.420,000 Rs.600,000 Rs.1,500,000

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In addition to annual and quarterly sales budgets, monthly budgets are often prepared so sales can be tracked against expectations more frequently than once every three months.

Manufacturing costs

Before preparing the direct materials, direct labor, and manufacturing overhead budgets, the production budget must be completed.

Production budget. The production budget shows the number of units that must be produced. To budget for annual production, three things must be known: the number of units to be sold, the required level of inventory at the end of the year, and the number of units, if any, in the beginning inventory. If quarterly budgets are required, this same information is needed on a quarterly basis. Using the Pickup Trucks Company's quarterly sales budget and given that 15% of the next quarter's sales volume must be on hand before the quarter begins, the production budget by quarter can be prepared. Further assumptions are a 10% increase in sales in quarter one of next year

compared to the current year's quarter-one sales and 2,250 units in inventory at the beginning of the year.

Pickup Trucks Company Production Budget in Units for 20X1

Sales 15,000 17,000 28,000 40,000 100,000

Required Ending Inventory 2,550 4,200 6,000 2,475 2,475

Units Required 17,550 21,200 34,000 42,475 102,475

Beginning Inventory (2,250) (2,550) (4,200) (6,000) (2,250)

Units to be Produced 15,300 18,650 29,800 36,475 100,225

Direct materials budget. The direct materials budget determines the number of units of raw materials to be purchased. It uses the number of units to be produced from the production budget, the required level of ending inventory for raw materials, and the number of units in beginning inventory. Once the

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number of units to be purchased is determined, it is multiplied by the cost per unit to determine the budgeted amount for raw materials purchases. The Pickup Trucks Company requires 10% of next quarter's production requirement for raw materials to be in its ending inventory. For example, because it takes five tires to make the special pickup truck (four plus the spare tire mounted on the side), at a cost of Rs.0.50 per tire, the raw materials purchases budget calculates 501,890 tires required at a cost of Rs.250,945. The units in the production budget are adjusted for units in ending and beginning inventories, multiplied by five (number of tires per pick up) to determine total tires to be purchased and then multiplied by Rs.0.50 to determine the cost of the tires needed. As a reminder, the production budget showed the following units for 20X1:

Units

Quarter 1 15,300

Quarter 2 18,650

Quarter 3 29,800

Quarter 4 36,475

Total 100,225

Pickup Trucks Company Raw Materials Budget For the Year 20X1


Units to be produced 15,300 18,650 29,800 36,475 100,225

Number of tires per unit Ã—5 Ã—5 Ã—5 Ã—5 Ã—5

76,500 93,250 149,000 182,375 501,125

Required ending inventory

9,325 14,900 18,238 8,415 8,415

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Total units required 85,825 108,150 167,238 190,790 509,540

Beginning inventory (7,650) (9,325) (14,900) (18,238) (7,650)

Units to purchase 78,175 98,825 152,338 172,552 501,890

Cost per unit Ã—Rs.0.15

Ã—Rs.0.15

Ã—Rs.0.15

Ã—Rs.0.15

Ã—Rs.0.15

Cost of raw materials purchases

Rs.11,726 Rs. 14,824 Rs. 22,851 Rs. 25,883 Rs. 75,284

This process is repeated for all the other raw material components used in producing a pickup truck.

Direct labor budget. The direct labor budget shows the number of direct labor hours and the cost of the labor to determine the total cost of direct labor. Assume it takes one-half hour of labor to put together one pickup truck and each labor hour costs Rs.14.00. The total direct labor budget is for 50,113 (100,225 units Ã— .5 hours per unit) hours at a cost of Rs.701,575 (Rs.14.00 per hour Ã— 50,113 hours). The break out by quarter is shown in the following table.

Pickup Trucks Company Direct Labor Budget For the Year 20X1


Units to be produced

15,300 18,650 29,800 36,475 100,225

Direct labor hours per unit

Ã— .5 Ã— .5 Ã— .5 Ã— .5 Ã— .5

Total direct labor hours

7,650 9,325 14,900 18,237.5 50,112.5

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Cost per hour Ã—Rs.14.00

Ã—Rs.14.00

Ã—Rs.14.00

Ã—Rs.14.00

Ã—Rs.14.00

Cost of direct labor

Rs.107,100 Rs.130,550 Rs.208,600 Rs.255,325 Rs.701,575

Manufacturing overhead. The manufacturing overhead budget identifies the expected variable and fixed overhead costs for the year (or other period) being budgeted. The separation between fixed and variable costs is important because the Pickup Trucks Company uses a predetermined overhead rate for applying overhead to units produced. In preparing its budget, the Pickup Trucks Company has identified the following variable and fixed costs: indirect materials Rs.0.50 per unit, indirect labor Rs.1.00 per unit, maintenance Rs.0.75 per unit, annual depreciation Rs.12,000, supervisory salaries Rs.24,000, and property taxes and insurance Rs.21,000. The budget by quarter is:

Pickup Trucks Company Manufacturing Overhead Budget For the Year 20X1


Variable Costs

Indirect Materials Rs.7,650 Rs.9,325 Rs14,900 Rs.18,238 Rs.50,113

Indirect Labor 15,300 18,650 29,800 36,475 100,225

Maintenance 11,475 13,988 22,350 27,356 75,169

Total Variable Costs 34,425 41,963 67,050 82,069 225,507

Fixed Costs

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Supervisory Salaries 3,000 3,000 3,000 5,700 14,700

Property Taxes and Insurance

6,000 6,000 6,000 6,000 24,000

Depreciation 5,250 5,250 5,250 5,250 21,000

Total Fixed Costs 14,250 14,250 14,250 16,950 59,700

Total Manufacturing Overhead

Rs.48,675 Rs.56,213 Rs.81,300 Rs.99,019 Rs.285,207

Total Direct Labor Hours 7,650 9,325 14,900 18,238 50,113

Predetermined Overhead Rate

Rs.5.70

Selling expenses budget

The budget for selling expenses includes the variable and fixed selling expenses. The variable expenses in the selling expenses budget are usually based on sales dollars. Assume the Pickup Trucks Company's variable expenses are sales commissions and delivery expense. Sales commissions are 4% of sales dollars, and delivery expense, also called freight out by some companies, is Rs.0.10 per unit sold. The company also has fixed sales salaries of Rs.50,000. The calculations for sales commissions and delivery expense, followed by the selling expenses budget, are shown in the following tables.

Pickup Trucks Company Sales Commission and Delivery Expenses Budget Calculations For the Year 20X1

Sales Commission Expense

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Sales Rs.225,000 Rs.255,000 Rs.420,000 Rs.600,000 Rs.1,500,000

Commission Rate 4% 4% 4% 4% 4%

Sales Commissions

Rs.9,000 Rs.10,200 Rs.16,800 Rs.24,000 Rs.60,000

Delivery Expense

Units Sold 15,000 17,000 28,000 40,000 100,000

Cost per Unit Rs.0.10 Rs.0.10 Rs.0.10 Rs.0.10 Rs.0.10

Delivery Expense Rs. 1,500 Rs. 1,700 Rs. 2,800 Rs. 4,000 Rs.10,000

Pickup Trucks Company Selling Expenses Budget For the Year 20X1

Variable Expenses

Sales Commissions Rs. 9,000 Rs.10,200 Rs.16,800 Rs.24,000 Rs. 60,000

Delivery Expense 1,500 1,700 2,800 4,000 10,000

Total Variable Expenses 10,500 11,900 19,600 28,000 70,000

Fixed Expenses

Sales Salaries 12,500 12,500 12,500 12,500 50,000

Total Selling Expenses Rs.23,000 Rs.24,400 Rs.32,100 Rs.40,500 Rs.120,000

General and administrative expenses budget

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The general and administrative expenses budget details the variable and fixed operating expenses for the general and administrative areas of the company. The Pickup Trucks Company has no variable administrative expenses. Its fixed expenses include salaries of Rs.60,000, rent expense of Rs.15,000, and office supplies of Rs.6,000.

Pickup Trucks Company General and Administrative Expenses Budget For the Year 20X1

Variable Expenses

None

Fixed Expenses

Salaries Rs.15,000 Rs.15,000 Rs.15,000 Rs.15,000 Rs.60,000

Rent Expense 3,750 3,750 3,750 3,750 15,000

Office Supplies 1,500 1,500 1,500 1,500 6,000

Total General and Administrative Expenses

Rs.20,250 Rs.20,250 Rs.20,250 Rs.20,250 Rs.81,000

Budgeted Income Statement

The budgeted or budgeted income statement is prepared after the operating budgets have been completed. The cost of goods sold on the income statement is calculated using the per unit cost of Rs.11.25, which consists of Rs.1.40 per unit for direct materials, Rs.7.00 per unit for direct labor, and a manufacturing overhead rate of Rs.2.85. The overhead rate is calculated by multiplying the predetermined overhead rate of Rs.5.70 per direct labor hour times the direct labor hours per unit of one-half hour.

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Quantity Unit Cost Total Cost

Direct Materials Various Rs. 1.40 Rs. 1.40

Direct Labor .5 hour 14.00 7.00

Manufacturing Overhead .5 hour 5.70 2.85

Total Unit Cost Rs.11.25

Pickup Trucks Company Budgeted Income Statement For the Year 20X1

Sales (100,000 Ã— Rs.15) Rs.1,500,000

Cost of Goods Sold (100,000 Ã— Rs.11.25) 1,125,000

Gross Profit 375,000

Operating Expenses

Selling Expenses Rs.120,000

Administrative Expenses 81,000

Total Operating Expenses 201,000

Income from Operations 174,000

Interest Expense 2,880

Income before Income Taxes 171,120

Income Taxes (40%) 68,448

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Net Income Rs.102,672

C ASH B UDGETING

The cash budget indicates how much cash the company will have on hand at the end of each period, and also indicates when the company will need to borrow funds to cover temporary cash shortfalls, and when the company will have excess funds to invest in short-term financial instruments.

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. Cash flow is so important that in some organizations, cash balances are projected for the end of each week, or even on a daily basis.

Often, the cash budget is assembled from supporting schedules. These schedules show, for the period being budgeted, anticipated cash disbursements and cash receipts that arise from (1) operating activities, (2) additions and disposals of fixed assets, and (3) financing activities.

The cash budget is one of the most important planning tools that an organization can use. It shows the cash effect of all plans made within the budgetary process and hence its preparation can lead to a modification of budgets if it shows that there are insufficient cash resources to finance the planned operations.

It can also give management an indication of the potential problems that could arise and allows them the opportunity to take action to avoid such problems. A cash budget can show four positions. Management will need to take appropriate action depending on the financial position.

Cash Position Appropriate management action

Short term surplusPay creditors early to obtain discount.Attempt to increase sales by increasing debtors and stocks.Make short term investments.

Short term deficitsIncrease creditors.Reduce debtors.Arrange an overdraft.

Long term surplus Make long term investments.Expand operations

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Diversify.Replace / update fixed assets

Long term deficitRaise long term finance. i.e. issue sharesConsider shut down or disinvestment opportunities.

Z ERO- B ASED B UDGETING

In the normal budgeting process, the previous year's level of expenditure is often assumed to have been appropriate. The task of individuals preparing the budget is to decide what activities and funds should be added or subtracted. Such a process builds into an organization a bias towards continuing the same activities year after year.

Zero-base budgeting, in contrast, enables the organization to look at its activities and priorities afresh. The previous year's resource allocation is not automatically considered as the basis of this year's allocation. Instead, each manager has to justify anew his/her entire budget request.

Uses of Zero-Based Budgeting

1. Efficient allocation of resources, as it is based on needs and benefits.2. Drives managers to find cost effective ways to improve operations.

3. Detects inflated budgets.

4. Useful for service departments where the output is difficult to identify.

5. Increases staff motivation by providing greater initiative and responsibility in decision-making.

6. Increases communication and coordination within the organization.

7. Identifies and eliminates wasteful and obsolete operations.

8. Forces cost centers to identify their mission and their relationship to overall goals.

Disadvantages of Zero-Based Budgeting

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1. Difficult to define decision units and decision packages, as it is time-consuming and exhaustive.

2. Forced to justify every detail related to expenditure. The R&D department is threatened whereas the production department benefits.

3. Necessary to train managers. Zero-based budgeting must be clearly understood by managers at various levels to be successfully implemented. Difficult to administer and communicate the budgeting because more managers are involved in the process.

4. Honesty of the managers must be reliable and uniform.

F LEXIBLE B UDGETING

A flexible budget is a budget that is prepared for a range i.e. for more than one level of activity. The flexible budget is also known as a variable, dynamic, sliding scale, step budget. The underlying principle for a flexible budget is that every business is dynamic and ever changing. Thus, a flexible budget is developed for a range, say 8000-10000 units of production. Under this approach, if the actual production is 9000 units compared to the projected amount of 10000 units, the manager uses the flexible budget to project the costs for 9000 units of output in place of the budgeted 10000 units. The flexible budget covers a range of activity, is easy to change with a variation in production levels, and thus facilitates correct performance measurement and reporting.

Steps in flexible budgeting

The following steps are involved in developing a flexible budget:

1. Deciding the range of activity to which the budget is to be prepared2. Determining the cost behavior patterns (fixed, flexible, semi-

variable) for each element of cost to be included in the budget3. Selecting the activity levels in terms of production levels to prepare

budgets at those levels4. Preparing the budget at the pre-determined level of activity

Uses of flexible budgets

The following are the main uses of a flexible budget:

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Accurate budgeting- Flexible budgets result in the preparation of more accurate budgets. Such budgets consider the output and accordingly estimate the costs to be incurred at that level of output

Accurate performance measurement- Flexible budgeting incorporates changes in activity levels and compares actual performance with the budget in terms of output achieved. This facilities more meaningful comparison and evaluation of performance.

Coordination- Flexible budgeting results in proper coordination between various departments of a company. For instance, if production is planned in relation to estimated sales, materials and labor are acquired to meet expected production needs

Control tool- Such a budget acts as a control tool. Comparisons between the budgeted costs (at the actual production level) and actual costs form the basis for analyzing cost variances and fixing responsibility for the same.

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Budget

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