Unit-5

Budgetary Control

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5.1. Concepts and Objectives of Budget and Budgetary
Control The concept of budget
Budget:
 Is the quantitative expression of a proposed plan of action by management for a future
time period and is an aid to the coordination and implementation of a plan.

 Is a financial or quantitative statement, prepared prior to a specified accounting period,
containing the plans and policies to be pursued during that period.

 Is a detailed plan, expressed in quantitative terms, that specifies how resources (materials
and human capital) will be acquired and used during a specified period of time.

A completely and precisely defined budgeting, therefore, contains the following:

1. Budgeting is related to planning
2. The component of budget

it should indicate the objective of the budget. E.g., producing 100,000 chairs.

means of achieving that objective by mentioning resources. Wooden and metal

it should indicate the required resources. 10 inches and 12 inches, respectively, to
make a chair.

it should indicate from where those resources are obtained. Input materials to be
purchased ABC supplier
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3. The budgetary period should be specified.

Objectives of Budgeting:
 Budgeting involves:
i. establishing specific goals,
ii. executing plans to achieve the goals, and
iii. periodically comparing actual results with the goals.
As such, budgeting has the following objectives:
1. Require Planning:
 Budgeting forces managers to think a head – to anticipate and prepare for changing
conditions.
2. Framework for Performance evaluation:
 Budgeted goals and performance are generally a better basis for judging actual results
than is past performance.
3. Coordination and Communication:
 Coordination is the interconnecting and balancing of all factors of production or service
of all the departments and business functions so that the company can meet its
objectives.
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 Communication is getting those objective understand and accepted by all the employees
in the various departments and functions.

4. Feedback:
 Budgets provide feedback to managers about the likely effects of their strategic plans.

Methods of establishing Budgets

 In establishing the budget allocation to specific profit centers, cost centers or
departments, there are five main methods of budgeting:
i. Rolling budgets: is a new, revised set of financial plan for the next accounting period
used to replace the prior one in a continuous budgeting system. Each time a period
ends the budget is rolled forward one period.
ii. Zero-based budgeting:
 It is a budgeting technique that allocates funding based on efficiency and necessity
rather than on budgeting history. It is a method of budgeting in which all expenses must
be justified and approved for each new period. 

 This method has the advantage of regularly reviewing all the activities that are carried
 out to see if they are still required, but has the disadvantage of the cost and time needed
for such reviews
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iii. Activity-based budgeting:
 identifies activities that consume resources and uses the concept of cost drivers
(essentially the cause of costs) to allocate costs to products or services according to how
much of the resources of the firm they consume.
iv. Priority-based budgets:
 allocate funds in line with strategy. If priorities change in line with the organization’s
strategic focus, then budget allocations would follow those priorities, irrespective of the
historical resource allocation.

 A public-sector version of the priority-based budget is the program budgeting.
v. Incremental budgeting:
 Takes the previous year’s budget as a base and add (or subtract) a percentage to give this
year’s budget.

 The assumption is that the historical budget allocation reflected organizational priorities
and was rooted in some meaningful justification developed in the past.

 It is the opposite of Zero-based budgeting.

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5.2. Types of Budgets
 There are different types of budgets. Some of these include:
1. Short-Term Budgets:
 These budgets are usually prepared for a period of one year.

 Sometimes they may be prepared for shorter period as for quarterly or half

yearly. E.g., Sales budget

2. Long-Term Budgets:
 Are prepared for a longer period varying between five to ten years. 

 It is usually developed by the top level management.

 These budgets summarize the general plan of operations and its expected

consequences. E.g., budgets for projects (e.g., Budget of Abay Renaissance Dam).

3. Static Budget:
 A budget that is prepared by assuming a fixed percentage of capacity utilization, it is


called as a fixed budget.
 Once the budget has been determined, it is not changed, even if the activity changes.

E.g., Governmental budgets.

 Disadvantage: they mostly do not adjust for changes in activity levels.
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4. Flexible Budget:
 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 and
capacity utilization, such as operating at 60%, 80% or 90% capacity.

5. Capital budget:
 A budget that details the planned expenditures for facilities, equipment, new products
and other long-term investments.

6. Master Budget:
 It is an extensive analysis of the first year of the long-range plan.

 It summarizes the planning activities of all subunits of an organization- sales,
production, distribution and finance.

 The master budget is an integrated set of operating, investing, and financing budgets for
a period of time.

 Most companies prepare the master budget on a yearly basis.

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For a manufacturing company, the master budget consists of the following integrated
budgets:

Master Budget

Operating Financial
Budget budget

Operating budget: Financial budget:

Sales (revenue) budget Cash budget
Production budget Capital budget
Direct materials usage and purchase budget Budgeted Income statement
Direct labor budget Budgeted balance sheet
Manufacturing overhead budget Budgeted statement of cash flows

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Operating budget
 The foundation of the operating budget is the revenue budget

 The operating budget ends with the budgeted income statement

Example:
 The following data relates to Ajax Ltd manufacturing for one month. 

Two pounds of direct materials are budgeted per unit at a cost of Br 2 per
 pound.

 Three direct labor hours are budgeted per unit at Br 7 per hour.

 Variable overhead is budgeted at Br 8 per direct labor hour.

 Fixed overhead is budgeted at Br 5,400 per month.

Variablenon-manufacturing costs are expected to be Br 0.14 per Birr of
 revenue.

 Fixed non-manufacturing costs are Br 7,800 per month.

 Ajax expects 1,100 units to be sold during the month of August 2009.

 Selling price is expected to be Br 240 per unit.

Desired ending materials inventory for equals

15 percent of the materials


required to produce next month’s sales.
September sales are forecasted to be 1,600 units.
Question: How much is budgeted revenue for the month?
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Step 1: Prepare the Sales (revenue) budget
 A revenue budget is the usual starting point in budgeting. Why? Because production and
hence costs and inventory levels generally depend on the forecasted level of unit sales or
revenues.
Selling price Birr 240
Units sold 1,100 units
Total budget revenue (1,100 units X Birr 240) Birr 264,000

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Step 2: Prepare the production budget (in units)
Budgeted Budgeted Target ending Beginning
Production = sales + finished goods - finished goods
(Units) (Units) inventory (units) inventory (units)

  
Assume that target ending finished goods inventory is 80 units
 
Beginning finished goods inventory is 100 units

Question: How many units need to be produced?

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 Ajax Ltd Manufacturing Production Budget
For the month of August 2009
Budgeted unit sales 1,100
Add: Target ending finished goods Inventory 80
Total finished units required 1,180
Less: beginning finished goods inventory (100)
Units to be produced 1,080

Step 3: Prepare the direct materials usage and direct materials purchases budgets
 The decision on the number of units to be produced is the key to computing the usage of
direct materials in quantities and in Birr.
 Physical units to be used in production are determined by multiplying direct material


usage per output by units to be produced.
 Cost of used direct material is determined by multiplying physical units to be used in
production by budgeted unit cost of the material (FIFO, LIFO, Average cost).

Question: What is the Direct material usage and purchase budget in August?

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Direct material usage budget (in units) = Budgeted production (units) X required direct
materials per unit
= 1,080 x 2
= 2,160 pounds
Direct material usage budget (in cost) = Direct material usage budget X budgeted material
cost per unit
= 2,160 pounds x 2 Birr
= 4,320 Birr
Purchase of Production Target Beginning
Direct materials = usage of + ending - inventory of
Direct inventory direct
Materials of direct Materials materials

Production usage (in pounds) 2,160

Add: ending direct materials inventory (1,600 units x 2 pounds x 15%) 480
Less: Beginning direct materials inventory (1,100 units x 2 pounds x 15%) (330)
Direct materials purchase budget (in pounds) 2,310
DM purchase budget (in cost) = 2,310 pounds x 2 Birr = Birr 4,620
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Step 4: Direct labor cost
 These costs depend on wage rates, production methods, and hiring plans.
Budgeted labor hours:
Units to be produced X Direct labor hours per unit
Budget Cost:
Budgeted labor hours X costs per direct labor hour
Direct manufacturing Labor Budget
For the month of August 2009
Labor – Hours Budget:
Unit produced 1,080
Direct labor hours/unit 3
Total direct labor hours required 3,240
Cost budget
Budgeted labor hours 3,240
Cost per direct labor hour 7
Total budget Birr 22,680

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Step 5: Manufacturing Overhead budget
 The total of these costs depends on how individual overhead costs vary with the assumed

cost driver, direct manufacturing labor-hours.
 They can be classified as variable and fixed
Manufacturing Overhead budget
For the month of August 2009
Variable overhead (3,240 labor hours x Birr 8) 25,920
Fixed overhead 5,400
Total 31,320

Product cost = DMC + DLC + MOC (UVC + UFC)

= 2 pounds x 2 birr + 3 hours x 7 Birr + 3 hours x 8 birr + 5,400/1080

= Birr 54

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Step 7: Cost of goods sold budget

Cost of Goods Sold

For the month of August 2009
Beginning finished goods inventory (100 units x Birr 54) Birr 5,400
Add: cost of finished goods manufactured (1080 units x Birr 54) 58,320
Cost of goods available for sale 63,720
Less: Ending finished goods inventory (80 units x Birr 54) 4,320
Cost of goods sold 59,400

Step 8: Non-manufacturing costs budget

 Non-manufacturing costs are classified as variable and fixed with respect to revenues.

Non-manufacturing costs budget

For the month of August 2009
Variable expenses ((1,100 units x Birr 240)x0.14) 36,960
Fixed expenses 7,800
Total 44,760

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5.3. Steps in Budgetary control
What is budgetary control
 Is concerned with ensuring that actual financial results are in line with targets

 An important part of the feedback process to investigating variations between actual
results and budgeted results and taking appropriate corrective action.

 Budgetary control provides a yardstick for comparison and isolates problems by focusing
on variances, which provide an early warning to managers.

 The budgeting process is the influencing of management behavior by setting agreed
performance standards, the evaluation of results and feedback to management in
anticipation of corrective action where necessary.

 Budgetary control is typically exercised at the level of each responsibility center.

 Based on standards (budget) and actual results, the management of a company whether
the company is in a Favorable or Unfavorable condition.

The steps involved in the budgetary control process include:

1. Identify business objective

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2. Forecast economic and industry conditions, including competition.
3. Develop detailed sales budgets by market sectors, geographic territories,
major customers and product groups.
4. Prepare production budgets (materials, labor and overhead) by responsibility center
managers to satisfy the sales forecast and maintain agreed levels of inventory.
5. Prepare non-production budgets by cost center, cash forecasts, capital
expenditure budgets.
6. Identify financing sources and requirements.
7. Prepare a master budget (profit and loss, balance sheet and cash flow).
8. Discuss at department, section, middle level management and at top level mgmt.
9. Agree at company/organization level on standards and budget, and document.
10. Implement agreed budgets and standards.
11. Coordinate and monitor activities
12. Provide feedback
13. Conduct section, department and company/organizational level evaluation.
14. Compare actual performance with budgets and standards
15. Take corrective action and revise future plans.

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 Unit-6
Standard Costing

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Concepts, types and purpose of standard costs
 During the evolutionary stage of costing, the focus was only on the determination of
actual cost.

 This resulted in lack of cost control measures to the management.

 As a solution, standard costing was developed by cost accountants to meet the
contingency standards for managerial purposes.
As such, Standard costing:
 Is a technique which uses standards for costs and revenues for the purpose of control
through variance analysis.

 Involves the setting of predetermined cost estimates in order to provide a basis for
comparison with actual costs.
A standard cost:


Is a planned cost for a unit of product or service rendered
 Is a predetermined calculation of how much costs should be under specified working
conditions

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 It is built up from an assessment of the value of cost elements and correlates of technical
specifications and the qualification of materials, labor and other costs to the prices
and/or usage rates expected to apply during the period in which the standard cost is
intended to be used.

Purpose (objectives) of Standard Costing and costs:

 To provide a formal basis for assessing performance and efficiency.

 To control costs by establishing standards and analyzing of variances.

 To provide basis for control through variance analysis, and basis for fixing selling
prices.

 To enable the principle of ‘management by exception’ to be practiced at the detailed
operational level.

 To assist in setting budgets.

Standard costing adopts the following steps to achieve the objectives.

1. Determine the standard for direct material, direct labor and the different overheads.
2. Ascertaining the actual cost of production

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3. Ascertaining the variances by comparing actual costs with standard costs.
4. Analyze the variances to know the reason for variances.
5. Adopting corrective measures to control the variances in futures.

Types of standards:

 In manufacturing companies, the most common standards are direct material usage
(quantity) and costs, direct labor hours and costs, and the different overhead costs.

6.2. Setting standards:

 Standards come from three main sources: experience, theoretical constructs, and
practical references.

Experience: Based on what was done in the past, it assumes those circumstances will
translate well into the future.
Example: Use what we did last year, add or subtract 10%.

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Advantages of standard setting:
If companies are good at standards setting, they can gain the following advantages.

Setting of standards results in the best resources usage and thereby increase
efficiency.

Easily compiling budgets from standards.

Actual costs can be compared with standard costs in order to evaluate
performance.

Helps to identify areas of strengths and weakness.

It acts as a form of feed forward control that allows an organization to plan the
manufacturing inputs required for different levels of output.

It acts as a form of feedback control by highlighting performance that did not
achieve the standard set.

It helps to operates through the management by exception where variances are
investigated outside certain tolerance limits; thus saves managerial time and
maximizes efficiency.

The process of setting, revising and monitoring standards encourages reappraised
of methods, materials and techniques thus leading to cost control as an immediate
effect and to cost reduction as a long term effect.

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However, be aware that standard costing also suffers the following limitations.
 A lot of input data is required which can be expensive.
 Unless standards are accurately set, any performance evaluation can be meaningless
or misleading.
 Uncertainty in standard costing can be caused by inflation, technological change,
economic and political factors, etc.
 Standards therefore need to be continually updated and revised.
 Setting of standards involves forecasting and is subjective judgments.
 It is difficult to adopt standard costing in firms that do not have uniform and standard
production program.

6.3. Variance Analysis

 The difference between the standard usage and cost and the actual usage and cost.

 The resolution into constituent parts and the explanation of resource usage variances.

 If actual usage or cost is less than the standard usage or cost, the variance is favorable.

 If the actual usage or cost is more than the standard usage or cost, the variance
is unfavorable.

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 A favorable variance indicates efficiency, while an unfavorable one denotes
inefficiency.

 However, mere knowledge of these variances would not be useful for ensuring cost
control. The causes and concrete reasons have to be thoroughly analyzed so as to find
out the contributory factors for the efficiency or inefficiency.

 Variances are of two types: cost variances and sales variances.

 Standard costing mainly focuses on cost variances (DMC, DLC and MOH).

Cost variances: The total cost variance can be split into its constituent parts, in order to
analyze the cost variances in detail.
Total cost variance

Direct material Direct labor Overhead

cost variance cost variance cost variance

Price Usage Rate Efficiency Variable Fixed

variance variance variance variance variance variance

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Direct material cost variance: is the difference between the standard cost of material
specified for the output achieved and the actual cost of materials used.
 The standard cost material is computed by:
DMCV= Standard Cost for Actual Output – Actual Cost
Or, (Standard Price × Standard Quantity for Actual Output) – (Actual Price × Actual Quantity)

Price variance: is the difference between the actual price and the budgeted price
multiplied by the actual quantity of input in question. Price variance is sometimes called
input price variances or rate variances.
Price variance = (Actual price of input – budgeted price of input) x Actual quantities of input.

Usage (efficiency) variance: is the difference between the actual quantity of input used
(such as inches or cloth of direct materials) and the budgeted quantity of input that should
have used, multiplied by the budgeted price. Usage variance is called efficiency variance.
Usage variance = (Actual quantity of inputs used – budgeted quantity of input allowed
for actual output) x Budgeted price quantities of input.

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Direct Labor Cost Variance: is the difference between the standard direct wages specified
for the activity achieved and the actual direct wages paid.

DLCV = Standard Cost for Actual Output – Actual Cost

or = (Standard Rate × Standard Time for Actual Output) – (Actual Rate × Actual Time)

Direct Labor Rate Variance: is the difference between the standard rate specified and the
actual rate paid. It is also called ‘rate of pay variance or wage rate variance.
Direct Labor Rate Variance = (Standard Rate – Actual Rate) x Actual Time

Direct Labor Efficiency Variance: is the difference between the standard labor hours
specified and the actual hours spent on the works. This variance is primarily concerned
with the standard wage rate.
Labor Efficiency Variance = (Standard Time for Actual Output – Actual Time) x Standard Rate

Example:
ABC Ltd company manufactures industrial product. It uses standard costing system when
developing its flexible budget amounts. In Jan 2015, 1000 finished units were produced.
The following information is related to its two direct manufacturing cost categories of
direct materials and direct manufacturing labor.

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Direct materials were 2200 kg. The standard direct materials input allowed for one output
unit are 2 kg at Birr 15 per kg. 3000 kg of materials were purchased at Birr 16.50 per kg. at
a total cost of Birr 49,500.
Actual direct manufacturing labor hours were 1625 at a total cost of Birr 33,150, standard
manufacturing labor time allowed is 1.5 hours per output unit, and the standard direct
manufacturing labor cost is Birr 20 per hour.
Required:
Calculate the direct material price and efficiency variances and direct manufacturing labor
price and efficiency variances. The direct materials price variance will be based on a
flexible budget for actual quantities purchased but the efficiency variance will be based on
flexible budget for actual quantities used.

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Solution
 Calculation of direct material variances:


◦ Direct Material price variance:

= (Actual price of input –Budgeted price of input) X total quantity of
input = (Birr16.50 -Birr 15.00) X 3,000 = Birr 4,500 (U).

◦ Direct material efficiency variance

= (Actual quantity of input – Budgeted quantity of input allowed for actual output)
X Budgeted price of input
= (2200 – (1000 x 2) X 15.00
= (2200 – 2000) X Birr 15.00 = Birr 3000 (U)

◦ Calculation of price manufacturing labor variance

= (Actual labor hour rate – Budgeted labor hour rate) x Actual labor hours used
= (Birr 20.40 - Birr 20) X 1625 hours = Birr 650 (U)

Direct manufacturing labor efficiency variance

= (Actual hours used – Budgeted hours allowed for actual output) X Budgeted labor hour rate
= (1625- (100 x 1.5) X Birr 20
=1625 –1500 X Birr 20 = Birr 2500 (U)

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