1. Budget Framework 2. Master Budget 3. Operating Budget 4. Financial Budget 5. Methods of preparing Budgets



PART 1 LESSON 2 BUDGETING METHODOLOGIES Budget Framework: An organization prepares budget for organization as a whole and for each of its subunits. Budgets provide a framework of reference, a set of expectations against which actual results can be compared. Organizations compare actual performance with expectations and plan again after considering the feedback

Budget Framework

1. MASTER BUDGET: coordinates all the financial projections in the organization’s individual budgets in a single organization wide budget. It encompasses expectations from both operating decisions and financing decisions. Operating decisions relate to acquisition and use of scarce resources. Financing decisions center on how to get the funds to acquire resources. The term master in “master budget” refers to it being a comprehensive, organization wide set of budget.



PART 1 LESSON 2 BUDGETING METHODOLOGIES An annual business plan or master budget called a summary budget is the formal budget approved by the top management. Budget is classified based on capacity, coverage, period or conditions. The following flow chart will give an idea.

Budgets Capacity Coverage

Period Short term budget Long term budgets

Condition Basic budgets Current budget



Functional budgets

Master budgets

The master budget gives a forecast profit & loss A/c and forecast B/S. The master budget is a complete presentation of the operating plans of the entire company for the relevant budget period. It is a basis for the successful financial planning and cost control. In the master budget costs are classified and summarized by types of expenses as well as by departments. Thus the master budgets throw very useful information to the mgt. the master budget often called summary budget represents a standard for the achievement of which all the departments will work. In accounts closing the actual happenings are recorded consolidated and summarized whereas in master budget the plans for the forthcoming year are recorded. The master budget is backed by a number of functional budgets. The steps involved in the development of master budget are given bellow.  Preparation of functional budgets for the forthcoming period.  Up and down adjustments to bring about harmony among different budgets.  Preparative of summary budget.  Budgeted P& L A/c.  Budgeted Balance Sheet.  Authentication of master budget by the BOD.



PART 1 LESSON 2 BUDGETING METHODOLOGIES The above steps may be represented in the form of a flowchart. Organizational objectives

Short term plans or budget

Long-term budgets

Cash flow budget Budgeted profit & loss A/c Budgeted balance sheet Master budget


OPERATING BUDGETS: i) Sales Budget (Revenue Budget): This provides the basis of all the other budgets. It is the starting point for budgeting process. Sales budgets make forecasts. Companies take into account past sales, sales trends, and general economic conditions, political and legal considerations, planned advertising and product promotion, and expected actions of firm’s competitors. This may involve high level staff involved exclusively in forecasting. ii) Production Budget: Based on sales forecasts production budget is prepared. This budget plans for the number of units to be produced. The total number of units to be produced depends upon the planned sales (Revenue budget) and the expected changes in inventory level. When sales are not stable throughout the period the managers must decide whether:



PART 1 LESSON 2 BUDGETING METHODOLOGIES (1) (2) (3) iii) To adjust production levels periodically to minimize inventory held, or To maintain constant production level and let the inventory rise and fall Just in time production aims at keeping the inventory levels extremely low by adjusting production Direct Materials usage Budget and Direct Materials Purchase Budget: The number of units projected to be produced in the Production Budget is the key in determining the Direct Materials usage in quantities and in dollars. The following are the steps involved in the preparation of direct materials budget. 1. 2. budget. 3. prepared.  The materials budget would show the quantity as well as cost each type of direct material required.  It also helps purchase schedule to avoid the situation of non-availability of material. Purchase budget: It shows the quantity and amount of purchase to be made during the budgeted period. The material budget shows the requirements of the organization during the budget period. However for the preparation of purchase budget it is a pre-requisite to ascertain the inventories to be maintained. The purchase budget includes the cost of 1. direct materials 2. indirect materials 3. purchase of services 4. purchase of finished goods for resale RukshiCA 5 The standard price for each item of material should be set. Finalizing the after standards for quality quantity and price the material usage budget would be The standard requirement of each item of material was to be finalized. On The quantity standards should also be finalized. The standardization of the basis of test runs and past performance the allowance for normal may be given. size colon and quality aspects would be as per requisite for finalizing the materials

PART 1 LESSON 2 BUDGETING METHODOLOGIES The important consideration that govern the purchase budget are the following 1) Opening stock and closing stock of materials and components. 2) Storage space. 3) Re-order point 4) Safety stock 5) Economic order quantity 6) Seasonal discounts. 7) Finance planning. The purchase manager responsible for the purchase budget should consider the trend in prices and the different markets to finalize the best possible deal for the organization. An example of a purchase budget is given bellow. KSKS foundation Pvt Ltd Direct materials purchase budget for the year ending March 31 2011 Material A stock 7000 Material 4000 70000 74000 2000 72000 Rs 5 360000

Desired (units)


Add: units required for 160000 167000 production 9000 158000 Less: opening stock (units) Rs 2 Unit price (Rs) 316000 Purchase cost (in Rs) iv)

Direct Manufacturing Labor Budget: These costs depend on wage rates,

production methods, and hiring plans. The volume of production planned and the units produced will be deciding factor in forecasting the direct manufacturing labor costs. After the production budget and sales budget are settled the various machine operations involved and services required can be arrived at the different grades of direct labor



PART 1 LESSON 2 BUDGETING METHODOLOGIES required to achieve the productions needs to be arrive at. Form the above the standard hours required to complete the production can be arrived at. The standard rates of labor can be ascertained and there by the total labor cost can be arrived at. The benefits of labor cost budget are 1) The direct and indirect labor required to meet the production are defined. 2) The different grades of labor required as set out in the labor budget would indicate the personnel department to plan the requirement and training of staff / manpower. 3) The labor cost would indicate the management the finance required for meeting the production plan. An example of labor cost budget is given bellow: Raman & co Pvt Ltd: Direct labor cost budget for the year ending March 31 2011 Units Product X Product Y to be Direct labor Total required 12000 21000 hrs Total labor cost @2 per hr 24000 42000 Rs 66000 produced 2000 3000 how per unit 6 7

v) Manufacturing Overhead Budget: The total of these costs depends how overhead costs vary with relevant cost driver. Different costing systems make different assumptions. For instance under Activity Based Costing, overheads are estimated using activities as cost drivers. In peanut butter type of costing, overheads are projected as a percentage of direct labor costs. Direct labor hours may sometimes be assumed as a cost driver. All expenses of indirect nature are covered under this lead variable overhead. It comprises of indirect materials undirected labor and indirect expenses. The indirect expenses include depreciation fringe benefits etc which helps us to find out the overhead recovery rate. The manufacturing overheads are classified into fixed and variable expenses. A careful study of the nature of expenses would be essential budget. The preparation of fixed overhead budget is very simple and easy. The items normally RukshiCA 7

PART 1 LESSON 2 BUDGETING METHODOLOGIES included in the fixed overhead budget all property taxes depreciation rent fire insurance etc. the variable overheads budget includes all indirect materials indirect labor and indirect expenses which vary according to production. An example of factory overhead budget is given bellow ABC Company Ltd Factory overhead budget for year ending 31.3.2011 (Anticipated activity of 120000 direct labor hrs) Supplies Indirect labor Power (variable portions) Maintenance cost (variable portion) Total variable overheads Deprecation Property taxes Property insurance Supervision Power (fixed portion) Maintenance (fixed portion) Rs 35000 Rs 4000 Rs 2000 Rs 22000 Rs 1500 Rs 5000 Rs 69500 Rs 155500 Factory overhead recovery rate is = 155500 1200000 = Rs 1.30 per direct labor hour vi) Ending Inventory Budget: The Direct Material, Direct Labor and Rs 10000 Rs 32000 Rs 30000 Rs 14000 Rs 86000

Manufacturing Overhead Budgets result in computation of unit costs. The production budget projects the ending inventory in units. The projected unit costs are applied to



PART 1 LESSON 2 BUDGETING METHODOLOGIES projected ending inventory units helps in calculating the costs of targeted ending inventory. vii) Other (Non production) Costs Budget (Selling and Administration Cost budget): This projects costs in the areas of value chain other than production. This includes projected costs for R & D, Marketing, Distribution, Customer service, Administrative Costs. These costs may be broken up into fixed and variable portion. Administration cost budget: The expenses coming under administration cost are more or less fixed in nature. It usually involves budgeting for top management functions like legal financial accounting management information services audit and taxation these budgets are prepared on pattern of fixed cost budgets. Selling and distribution cost budget: Selling costs are incurred for maintain the sales. After production the products have to be sold to earn profits out of them. The following items form part of the selling and distribution cost i. ii. iii. iv. v. vi. Cost of creating demand & securing orders. The salespersons’ salaries commission and traveling expenses would be covered under this. Sales promotion advertising etc. Cost of delivering orders: the costs of packing storage freight billing etc be included. Cost of credit and collection. General sales office expenses. After sale services would

vii. Market research The selling costs are incurred to increase the volume of sales. A relationship between the selling costs and to determined the amount of selling costs to be incurred to achieve the desired volume of sales. Distribution cost has been defined as the cost of the sequence of operations that begins with making the packet of product available for dispatch and ends with making the reconditioned return of empty package if any available for re-use. It includes transport cost storage and warehousing costs etc.



PART 1 LESSON 2 BUDGETING METHODOLOGIES Production cost budget: The productions cost budget expenses the production units in money the direct material, direct labor and overhead cost budget production cost budget. Cost of goods sold budgets (COGS Budget) The COGS budget represents the cost of producing the products sold for a period this budget is a summary of the production budget direct materials direct labor overhead budgets and the cost of ending inventory of finished products. An illustration of the cost of goods sold budget is given bellow. Cost of goods sold budget for the year ending March 31.2011 of ABC LTD. Amount (in Rs) Direct materials used Direct labor Factory overhead Total manufacturing Add: finished goods (opening) Less: finished goods (closing) Total cost of goods sold called production cost budget. 420000 250000 120000 790000 110000 80000 820000 we can terms. It is a prepare the summary of the material cost. Labor cost and overhead cost budgets. After preparing

If the adjustments for opening and closing stock of finished goods are given then it is




The diagrammatic representation of short-term budgets is given bellow Short-term plans or budgets

Plant utilization

Productions budgets

Direct material budget

Inventory budgets

Sales budget Sales forecast budget Marketing budget Selling & distribution cost budget

Direct labor budget Manufacturing overheads budgets Administration overheads budgets

3. FINANCIAL BUDGET: The financial budgets emphasize on obtaining funds needed. A Financial Budget consists of i) Pro forma Income Statement provides a budgeted Income statement using budgeted operating budgets ii) Capital budget iii) Cash budget iv) Pro forma balance sheet (based on capital budget and cash budget) v) Pro forma statement of cash flows




i) Pro forma (budgeted income statement): The various parts of the operating budget are used to prepare a pro-forma income statement. It will show the result of the operations at the end of the year. The result would be profitable if the company meets its budget and if its assumptions prove to be correct. However when the budgeted income falls short of the goal the management known it must take corrective action. Therefore, for evaluating the performance a budgeted income statement would act as a benchmarking. An example of a Proforma income statement is given bellow. Proforma income statement for the quarter earned March 2011 of XYZ co Ltd Sales Less: cost of goods sold Rs 1000000 Rs 5300000 Rs 4700000 Less: selling & administration costs Rs 700000 Operating income Less: interest expenses Earning before taxes Less: taxes Net income ii) Capital budget Financing and investment are two important functions of financial management. The investment of funds requires a number of crucial decisions to be taken in which funds are invested and benefits are expected over a long period. The assets of a firm are broadly the classified into fixed and current assets is known as capital budgeting. The management is required to of a lot of crucial work like project planning commercial evaluation of projects, feasibility study-technical and financial etc. Meaning of capital budgeting The term capital budgeting means planning for capital assets. It invested detailed analysis as to whether or not money to be invested in long-term projects. Some examples Rs 4000000 Rs 1300000 2700000 400000 Rs 2300000



PART 1 LESSON 2 BUDGETING METHODOLOGIES are installing a machinery or setting-up of a factory or creating additional capacity etc. It includes a financial analysis of various proposals and to choose one best out of the available alternatives. The decision to invest in fixed assets is irreversible the decision should be made very carefully. The capital budgeting decisions involve current outlays but are likely to produce benefits over a long period. Reasons for the importance of capital budgeting decisions I. Heavy capital expenditure: as the very high decision has to b taken after careful consideration the scarce resources available for an organization are to b utilized effectively to produce profitable results. II. Long time period: the capital budgeting decisions impact a long period of time. It may even impact the growth and direction of the firm. III. Irreversible: nature: once funds are committed to a capital asset it is very difficult to reverse the decision. IV. Complex decision: before deciding on the capital investment a lot of alternative proposals are analyzed. It involves assessment of future events which may be very difficult to predict. For all investment decisions a cost-benefit analysis has to be made and in some cases it may be very difficult to quality the costs or benefits. V. Implied sales forecast: the investment in fixed represents an implied forecast of futures sales. Sometimes the investment of funds in plant and machinery very much depends on the sales forecast for the next 10 to 15 years. The long-term plans or budgets are represented below.




Long-term plans or budgets Capital budget

R & D budget Manpower budget

Cap. Ex. Budget

Cap. Ex. means CAPITAL EXPENDITURE iii) Cash budget: It represents the cash requirements of the business during the budget period. It is a plan of the receipts and payments for the budget period. Cash budget is a forecast of cash flows built on certain assumptions and past patterns. The cash budget preparation should be done in proper co-ordination with other functional budgets certain expenses like employees on a regular basis. The preparation of cash budget is based on the following information. i. Daily estimate of cash receipts ii. Daily estimate of cash disbursements iii. Time-lay unused by credit transactions iv. Time-lay in revenue & expenditure The following are objectives of cash budget i. The cash budgets would throw light on the cash position of the company so that they can plan its purchases and avail the maximum possible discounts.



PART 1 LESSON 2 BUDGETING METHODOLOGIES ii. The forecast cash flow would also reveal the excess cash available & the management may think of investing the excess cash in profitable avenues. iii. The cash budget will have sum that the business proposes itself for additional finance if required. iv. It helps a great deal in planning the cash flows. The cash budget is prepared by any one of the three methods i. Receipts and payments method. ii. Adjusted profit or loss account method. iii. Balance sheet method. Receipts and payment method: It is a very simple method. All receipts and payments which are expected during the period are covered under cash budget. Cash requirements of all the functional budgets are taken into account. Moreover, adjustments are excluded. An illustration is given bellow Prepare a cash budget based on the following information Cash on hand on 1.1.2010 is Rs 152000 Month Sales Materials Wages Production Selling & &Administrative distribution January 140000 45000 18000 16000 8000 February 188000 60000 23000 19000 12000 March 180000 55000 22000 16000 11000 April 195000 65000 25000 21000 13000 May 206000 75000 40000 25000 15000 June 220000 80000 45000 30000 16000 It is given that 50% are cash sales capital expenditure of Rs 20000 and 35000 is expected in the month of February & April. A bank loan of Rs 70000 is expected in the month of May. Debtors are accounted one month credit. A dividend of Rs 80000 is expected to be paid during the month of June creditors grant one moth credit sales commission is @4% of sales. Solution: cash budget Receipts




Opening balance Cash sales Debtors cash bank loan

January 152000 70000

February March 174400 21188 94000 70000 0 90000 94000 18400 0 45000 60000 22000 16000 11000

April 279680 97500 90000 187500 0 55000 25000 21000 13000 35000

May 310380 103333 97500 70000 270500

June 326080 105000 103000 208000

222000 payments material wages production administration cost selling cost capital expenditure dividend sales commission closing balance 174400 5600 47600 distribution & 18000 16000 80000


65000 40000 25000 15000

75000 45000 30000 16000

23000 19000 12000 120000 7520 126510 200880

80000 7200 11620 0 27968 0 7800 156800 310380 8240 153240 326080 8800 254800 279280

Adjusted profit & loss account is used as a basis for making the cash forecast. This method works under the assumption that profit is equivalent to cash. The adjustment made to the profit are added back of they don’t involve cash outflow. Some examples of items added back to the profit are depreciation accrued expenses etc. the procedure for preparation of cash budget from the profit & loss A/c is detailed bellow. i. Cash balance at the beginning of the period. ii. Net profit as reflected in the P&C A/C is added to the opening cash balance. iii. Non-cash items like depreciation outstanding expenses are added to the profit. iv. Capital receipts are added to the opening balance. RukshiCA 16

PART 1 LESSON 2 BUDGETING METHODOLOGIES v. Capital expenditure reduces the cost balance. vi. Adjustments for current assets and current liabilities. Balance sheet method Under this method a forecast balance sheet is prepared considering the changes in all items expect cash balance.

IV) Proforma (or budgeted) balance sheet It is Proforma balance sheet prepared at the end of the budget period. The prior year budget is taken as a base, changes effected in assets liabilities, and equity is incorporated in the budget balance sheet. The Proforma balance sheet is also called as budget balance sheet or statement of financial position. v) Proforma (or budgeted) statement of cash flows: The Proforma statement of cash flows throws light on the projected source and uses of funds. The Proforma statement of cash flow is prepared from Proforma income statement and Proforma balance sheet the sources and uses of funds of the company reveal the pattern of cash flows. The cash flow may be divided into three categories. 1) Operating activities. 2) Investing activities and 3) financing activities The cash flows resulting from operations are categorized under operating cash flows. The cash flows pertaining to buying and selling of assets come under the head investing activities. The cash flows relating to repayment of debt repurchase of equity and cash payments of dividend are covered under the head financing activities. PROFORMA FINANCIAL STATEMENTS AND BUDGETS:



PART 1 LESSON 2 BUDGETING METHODOLOGIES The operating budgets and financial budgets together from the master budget. The Proforma income statement is derived from the operating budgets. Based on the cash budget and capital expenditure budget a Proforma balance sheet is prepared. In addition, adjustment should be made in the Proforma balance sheet pertaining to retained earnings after the dividend outgo is determined. From the Proforma income statement and Proforma balance sheet, a Proforma statement of cash flows is prepared. The relationship between Proforma financial statements and budgets are given bellow.

Sales budget COGS budget production overhead budget administration cost budget, selling & distribution budget

Budgeted (Proforma) income statement Capital budget Budgeted (Proforma) balance sheet Proforma (budgeted) income statement Budgeted (Proforma) statement cash flows. Budgeted (Proforma) balance sheet Cash budget

Creating a Proforma income statement with the percentage of sales method: The process of preparing operating budgets and then to prepare Proforma income statement is time consuming and tedious. Hence a short-cut approach known as percentage of sales method is adopted. The percentage of sales method is a simple that works on the assumptions that many of the items is the Proforma income statement and



PART 1 LESSON 2 BUDGETING METHODOLOGIES balance sheet and profit and cost A/c grow proportionally with the sales. All the operating activities are assumed to grow in direct proportion with sales. None of the financing activities grow proportionally with sales. ASSESSING ANTICIPATED PERFORMANCE USING PROFORMA

FINANCIAL STATEMENTS The main objective of preparing the Proforma financial statement is to compare them with the predetermined financial targets. One of the ways of accomplishing the objective is to calculating the financial ratios and compares them to per-determined targets and industry averages. The formula for calculating the financial ratios are given below. 1. Current ratio = Current assets Current liabilities 2. Acid-test ratio (quick ratio) = (current assets – inventories) Current liabilities 3. ROA (return on assets) = net income Average total assets 4. ROE (return on equity) = net income Average equity 5. Gross profit margin percentage = gross profit Sales 6. Operating profit margin percentage = 7. Net profit margin percentage = operating income Sales net income Sales



PART 1 LESSON 2 BUDGETING METHODOLOGIES 8. Debt total assets ratio = total debt Total assets 9. Interest coverage or (times interest earned) = Where EBIT = earnings before interest and taxes. 10. Basic EPS earnings per share = (net income – preferred stock dividends) Weighted average common stock share outstanding. Illustration 1: Given bellow are the balance sheets of A Ltd & B Ltd as on 31.3.2010. Balance sheet Liabilities Equity shares 9% preferences shares Reserves & surplus General Reserve P&L A/C Secured loan 11% term loan 10% debenture Unsecured loan 15% bank loan 18% short term loan Current liabilities & provision Sundry creditors Outstanding expenses Provisional taxes 15 6 17 3 5 1460 1296 1460 25 20 35 20 60 110 600 120 200 70 60 A Ltd 600 150 B Ltd 500 100 Assets Fixed assets Investments Current assets and loans and advantages Inventories Sundry debtors Cash & B/c Debtors Advances 180 120 11 15 60 70 5 45 200 A Ltd 850 120 930 250 B Ltd EBIT Interest expenses

40 1296 Calculate the capital structure ratio RukshiCA



i. owners equity = 750 Total equity 1296 =0 .58 ii. debt Equity = 195 750 = 0.26

600 1460 = 0.41 755 600 = 1.26

Conclusion: B Ltd is highly leveraged in comparison to A Ltd. B Ltd is heavily dependent on long-term debt. The leverage is favorable to equity shareholders if the rate of return in higher than the rate of interest.

The following are various methods of preparing budgets PROJECT BUDGET: Consists of costs expected to be attached to a particular project. i) Project costs need to be tracked separately ii) Project budgets must be in alignment with organization’s operations and financial budgets ACTIVITY BASED BUDGETING (ABB): i) Applies activity based costing principles in budgeting ii) Focuses on numerous activities necessary to produce and market goods and services and requires analysis of cost drivers iii) Budget line items are related to activities performed ZERO BASED BUDGETING (ZBB): A method of budgeting requires the managers of decision units to prepare a budget with out any reference to the part budgets. It is an expenditure control device. The managers of decision units have to justify each and every rupee proposed to be spent.



PART 1 LESSON 2 BUDGETING METHODOLOGIES In the words of peter. A. pyhm, “ZBB is an operating planning and budgeting process which requires each manager to justify his entire budget requests in detail from scratch. (Hence zero-base). Each manager has to justify why he should spend money at all.” It is a very challenging approach. The process is completely contradictory to traditional budgeting. Traditional budgeting starts with a previous year expenditure as a base and “cuts and additions” are made to the previous year budget. The cuts and additions are to be justified before it is approved by the top mgt. In ZBB each business unit should convince the top mgt regarding the budget allotment. Each business unit would be subjected through analysis before approval. In ZBB the manger of each business unit has to justify his entire budget in complete detail with a zero base. Each item of the budget is analyzed and ranked in order of importance. Features of ZBB: 1) The technique deals with all the elements of budget proposals. 2) Previous year’s budget or expenditure is not at all considered. Budget allotment is made afresh and each units budget allocation is completely justified. 3) All the activities are broken up into decision packages 4) A critical evaluation of all the decision packages is made afresh. 5) The decision packages are ranked in the order of priority. 6) It provides the manager a combination of choices for arranging proposals. Process of ZBB: The following steps are involved in the ZBB. (a) (b) (c) (d) (e) Determination of a set of objectives is an important per-requisite of ZBB. Identification of the decision packages or decision units. The decision packages are linked with the corporate objectives. The decision packages are valid and ranked in order of priority. The decision packages are translated into practicable units, items for allocating

financial resources and thereby a budget is prepared.



PART 1 LESSON 2 BUDGETING METHODOLOGIES Advantages of ZBB 1) ZBB is an extension of the cost benefit analysis to the area of corporate planning and budgeting. 2) It provides a number of advantages to the organizational efficiency and effectiveness. 3) It stresses that all spending in the organization is challenged. 4) The process of ZBB would highlight very useful facts of great importance to the management. 5) It provides a systematic approach for the evaluation of different activities. 6) It compels the management to allocate the scarcer resource of the organization to projects ranked in the order of importance. 7) It drivers the managers with the ability to innovate and analyzes can make successful claims. The mangers should be self-driven to find out cost effective ways to improve operations. 8) It is an effective managerial technique which sets out the best alternatives available for a company. 9) The technique can also be used for the implementation of the system of “management by objective” Limitations of ZBB: 1) It is time consuming and costly. It needs properly trained managerial to do the require job. 2) For implementing ZBB the companies have to do an exhaustive analysis of the decision packages. 3) In ZBB the mangers have to justify their budgets in complete detail. Nothing is taken for granted. The mangers have a tough task ahead of them. 4) For implementing ZBB the managers have to understand the techniques well to successfully implement them. FLEXIBLE BUDGETING:



PART 1 LESSON 2 BUDGETING METHODOLOGIES Flexible budget is designed to change in accordance with the level of activity actually attained. A budget which by recognizing the difference in behavior between fixed and variable costs in relation to changes in output, turnover or other variable factors such as number of employees is designed to change appropriately with such fluctuations. Flexible budget is also known as variable or sliding scale budget. The main feature of flexible budget is that it gives expenditure at various levels of activity. For different levels of activity we can extract the expenditure and compare it with the actual for better performance. Flexible budgeting helps a great deal in performance evaluation. i.e. the actual cost at actual activity is compared with eth budgeted thereby deviations are analyzed and corrective action may be taken. Using the flexible budget methodology it is possible to establish budgeted costs for any range of activity. i. Fixed ii. Variable. iii. Semi variable. Semi variable expenses are further segregated into fixed and variable expenses. One of the important per-limitative of flexible budgeting is that the cost have to be categorized into fixed variable and semi variable costs. In-depth cost analysis and cost identification is required for the preparation flexible budget. Fixed items of expenditure will be the same for all levels of activity. Expense of variable nature is identified and variable cost per unit is determined. There by the cost is estimated for any level of activity. For semi-variable expenses special efforts are to be taken to identify the same. Steps in the preparation of flexible budget. 1. The budget is defined. 2. Cost categorization is done i.e. fixed variable and semi-variable costs. 3. Analyses the cost behavior patterns in response to past levels of activity. 4. Preparation of flexible budget for specified levels of activity. Performance flexible budgeting Practically there may be difference between the planned level of activity and actual; level of activity. In such cases the budgeted costs at the actual level of activity are determined



PART 1 LESSON 2 BUDGETING METHODOLOGIES and compared with the actual costs. This information would help the management to control the durations for ex. A business is expected to produce 100000 units during a given period. The business actually produces only 800000 units. In such a case the budget or profit plan for 100000 units would not be suitable. The budgeted costs for 800000 units would then be prepared and the actual costs would be compared with the budget.

Flexible budgeting illustration 1. A factory which expects to operate 70000 hrs at 70% level of activity furnishes details of expenses as under: Variable expenses Semi variable expenses Fixed expenses = Rs 12600 = Rs 1200 = Rs 18000

The semi-variable expenses go up by 10% between 85% and 95 % activity and by 0% above 95% activity. Construct a flexible budget for 80, 90 and 100% activities. Solution: Head account Budgeted hrs Variable exp Semi variable exp Fixed exp Total exp Recovery rate per hour 70% 70000 Rs 12600 Rs 12000 Rs 18000 4260 0.61 80% 80000 Rs 14400 Rs 12000 Rs18000 44400 0.55 90% 90000 Rs 16200 Rs 13200 Rs18000 47400 0.53 100% 100000 Rs 18000 Rs 14400 Rs 18000 50400 0.50

Conclusion: At 80% level of activity if the company has incurred an expenditure of Rs 45000 then it is concluded but over-spent by Rs 600.

2. A company produces product M and its sales at 80% capacity were at Rs 60000 Administration costs RukshiCA 25

PART 1 LESSON 2 BUDGETING METHODOLOGIES Office salaries = 9000 General expenses Depreciation Rates & taxes Selling costs salaries Traveling expenses Sales office expenses General expenses Distribution costs Wages Rent Other expenses = Rs 1500 = 1% of sales = 4% of sales = 2% of sales = Rs 750 = Rs 875 = 8% of sales = 2% of sales = 1% of sales = 1% of sales

Draw up flexible administration selling and distribution costs budget operating at 90% 100% and 110% of normal capacity Solution: In the absence of important it has been assumed that the office salaries depreciation rates taxes remain the same @ 110% capacity. Flexible budget of product M Expenses Sales administration costs Office salaries General expenses Depreciation Rates & taxes Total administration costs Selling costs salaries Traveling expenses Sales office expenses Fixed 2% of sales Fixed Fixed Basis Levels of capacity 80% 90% 60000 67500 9000 1200 750 875 11825 4800 1200 600 9000 1350 750 875 11975 5400 1350 675 100% 75000 9000 1500 750 875 12125 6000 1500 750 110% 82500 9000 1650 750 875 12275 6600 1650 825

8% of sales 2% of sales 1% of sales



PART 1 LESSON 2 BUDGETING METHODOLOGIES General expenses Total selling costs Distribution costs Wages Rent Other expenses Total admin, selling distribution costs & 1% of sales 600 7200 1500 600 2400 23525 675 8100 1500 675 2700 24950 750 9000 1500 750 3000 26375 825 9900 1500 825 3300 27800

Fixed 1% of sales 4% of sales

CONTINUOUS (ROLLING) BUDGET: Budget is revised on a regular (continuous) basis. i) Budget is extended a month or a quarter based on additional data ii) The advantage is that it requires managers to always think ahead iii) But disadvantage is preparation INCREMENTAL BUDGETING:  In this type of budgeting the prior year’s budget is taken as a base.  It starts with a prior year’s budget and uses the projected changes in the costs and sales and the adjustments are made to the prior year budget.  The changes in the operating environment compared to the last year are also adjusted in the prior year budget.  The concept of incremental budget is exactly opposite of zero-base budgets.  There is a possibility that the inefficiencies existed in the prior year my get carried forward to the future years.  It is also possible that some unnecessary expenses incurred in the prior year may get approval the management and the middle level managers may take certain approvals for granted. KAIZEN BUDGETING In Japanese, Kaizen means continuous improvement. RukshiCA 27 managers have to spend too much time on budget

PART 1 LESSON 2 BUDGETING METHODOLOGIES i) It requires estimates of the improvements and costs for their implementation ii) Kaizen is not based on existing system but on the changes to be made iii) Budget targets are target costs. The target costs can be achieved through improvements STATIC BUDGET It is based on one level of sales or production. This is in contrast with flexible budget where series of budgets are prepared for many levels of activity LIFE CYCLE BUDGET: i) Estimates a product’s revenues and expenses over its entire life cycle ii) Life cycle budgeting accounts for costs at every stage of value chain (R & D, design, production, marketing, distribution, and customer service) iii) Life cycle budgeting emphasizes the relationships among costs incurred at different value chain stages iv) Life cycle budgeting highlights the distinction between incurring cost s and locking in costs v) Life cycle concepts are also helpful in target costing and target pricing



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