Managerial Accounting

1
Budgeting

Module 006: Budgeting

Course Learning Outcomes:

At the end of this module, the student will be able to:
1. Define budget and other terminologies used in budgeting.
2. Know the advantage and limitations of budgeting.
3. Prepare a master budget and its related schedules.
4. Prepare operating and financial budgets using the flexible budget model.
5. Describe the different models of budgeting.
6. Relate budgeting to standards-setting, planning and controlling function
of management.

Definition of Budget
Budget is a detailed plan, expressed in quantitative terms, about business operations for a
specific period. It is a useful tool for planning and controlling company expenses, cash
flows, and earnings. The term budgeting is used to denote the process of coming up with
budgets.

Advantages and Limitations of Budgeting

Uses/Advantages of Budgeting
 It forces managers to plan for the
future.
 It provides a means of
communicating management’s plans
throughout the entity.
 It directs the activities toward the
achievement of organizational goals.
 It coordinates the activities of the
entire entity by integrating plans of
various parts.
 It provides a means of allocating
resources to segments efficiently
and effectively.
 It defines goals that serve as
benchmarks for evaluating
subsequent performance
Limitations of Budgeting
 Considerable time and costs are
required.
 Budgets are merely estimates that
require judgment and might be
modified or revised if necessary.
 A successful budgetary system
requires cooperating of all
members of the organization.
 Budgets sometimes restrict the
flexibility of the decision-making
process.
 The budget program is merely a
guide, not a substitute for good
management ability.

Course Module
The Master Budget
Master budget is a comprehensive budget that consolidates the overall plan of the
organization for a specified period. The master budget is mainly composed of:
1) Operating budgets
2) Financial budgets
The master budget, in some organizations, is also referred to as pro forma budget, planning
budget, forecast budget, and master profit plan.

MASTER BUDGET

OPERATING BUDGET FINANCIAL BUDGET

Sales budget Cash budget
Production budget Budgeted balance sheet
Direct materials budget Budgeted cash flow statement
Direct labor budget Capital expenditure budget
Factory overhead budget Working capital budget
Budgeted cost of goods sold
Budgeted operating expenses
Budgeted net income
Budgeted income statement

Terminologies Used in Budgeting

FIXED BUDGET
FLEXIBLE BUDGET
CONTINUOUS BUDGET
ZERO-BASED BUDGETING
IMPOSED BUDGETING
PARTICIPATORY BUDGETING
BUDGET COMMITTEE
A budget prepared for a one level of activity within a
certain period. Other term is static budget.
A budget prepared for different levels of activity
within a certain period. Other terms are variable
budget and sliding scale budget.
A 12-month budget that rolls forward one month as
the current month is completed. Other term is
perpetual budget.
A method of budgeting in which managers are
required to justify all costs as if the programs involved
were being proposed for the first time.
A process wherein budgets are developed are
prepared by top management with little or no inputs
from operating personnel.
A process wherein budgets are developed through
joint decisions by top management and operating
personnel.
A group of key management persons responsible for
over-all policy matters relating to the budget program
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Budgeting

and for coordinating the budget preparation.

BUDGET MANUAL This describes how a budget is prepared and includes
a planning calendar and distribution instructions for
all budget schedules.

The Sales Budget

Sales indicate meeting customers’ wants, demands, needs, and desires. It is the force that
induces the creation of business organization. It is the motive of business organization and
the genesis of normal business planning.
Mathematically, sales are affected by the unit sales price and quantity sold. The unit sales
price is affected by cost, competition, product substitutes, market trends, government
regulations, demand and supply behavior, and estimated profit, among other things. The
number of units sold is affected by the unit sales price.
Other factors influencing sales forecast include the past sales volume, general economic
and industry conditions, relationship of sales to economic indicators (such as gross
domestic product, gross national product, personal income, employment, prices and
industrial production), relative product profitability, market search studies, advertising
and other promotions, quality of sales force, seasonal variations, production capacity, and
long-run sales trends for various products. In forecasting sales, factors that have strong
correlation with sales pattern are identified and used.
Basically, there are three ways of making estimates for the sales budgets:
a. Statistical forecasting based on analysis of general business conditions, market
conditions, product growth curves, etc.
b. Make an internal estimate by collecting the opinions of executives and sales staff.
c. Analyze the various factors that affect sales revenue and then predict the future
behavior of each of these factors.
The estimated number of units sold could be estimated per product line, department,
geographical area, model, and market classification. In projecting units to be sold, several
forecasting techniques are employed which normally apply the concept of probability and
expected value. The study of probability and forecasting techniques are reserved in the
quantitative techniques applied in business.

Illustration: Estimated Sales in Units and in Pesos

The management of New Corporation is considering a three state economic conditions:
strong, fair, and weak. Based on some macro studies, it has been agreed that the economy
in the coming year may be 40% strong, 50% fair and 10% weak. The projected number of
units are 120,000 units, 90,000 units, and 50,000 units for strong, fair, and weak economic
conditions, respectively. The budgeted unit sales price given the estimates in units sold is
P120. Five percent (5%) of the gross sales are estimated to be uncollectible.
Required:
1. What are the budgeted units to be sold for the coming year?
Course Module
 2. What is the budgeted amount of sales, net of doubtful accounts?
Solutions/Discussions:
1. The budgeted sales in units shall be determined as follows:
Projected Sales Budgeted
Econom Probabilit
y Units y Unit Sales
120,00
A 0 40% 48,000
B 90,000 50% 45,000
C 50,000 10% 5,000
Total 93,000

2. The budgeted net sales in pesos shall be:

Budgeted sales in units 93,000
x Unit sales price P120
Budgeted gross sales in pesos P11,160,000
Less: Allowance for doubtful accounts
(P11,160,000 x 5%) 558,000
Budgeted net sales in pesos P10,602,000

In the following discussions, the unit sales price and projected sales in units are
normally given.

The Production Budget

Budgeted production is based on budgeted sales and inventory policies. An inventory
policy is normally based on the number of units to be sold in the following period. The
formula for the budgeted production could be derived from the traditional method of
determining number of units sold which states that finished goods inventory-beginning
plus production less finished goods inventory-ending equal budgeted sales. You tweak the
formula and the computation for the budgeted production is as follows:
Projected sales x
Add: Finished goods inventory - end x
Total goods available for sale x
Less: Finished goods inventory - beg x
Budgeted production x

The Raw Materials Budget

The raw materials budget is based on budgeted production. Multiply the budgeted
production by the standard materials per unit of finished goods to get the budgeted direct
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Budgeting

materials to be used. Then, add the materials inventory ending and deduct the materials
inventory beginning to get the budgeted materials purchases.
In understanding the derivation of raw materials purchases, it would help to revisit the
computation of raw materials used which is raw materials inventory-beginning plus
materials purchases less raw materials inventory-ending. From this standpoint, the raw
materials purchases are derived, as shown below.
Budgeted raw materials used (Budgeted production x Std. materials per unit) x
Add: Materials inventory - end x
Total materials for use x
Less: Materials inventory - beg x
Budgeted raw material purchases in units x
x Materials cost per unit x
Budgeted materials purchases in pesos Px

The Direct Labor Budget

Let us assume a labor-intensive operation where workers are paid by hour. On this
premise, the budgeted direct labor hours equal budgeted production times the standard
direct labor hour per unit produced. The standard direct labor rate per hour is to be
supplied by the Human Resources Department.
Budgeted direct labor hours (Budgeted production x Std. DLH per unit) x
x DL rate per hour Px
Budgeted DL cost Px

The Factory Overhead Budget

The factory overhead should be budgeted separately for the fixed overhead and the
variable overhead components.
Fixed overhead is constant in total and the fixed overhead rate is computed based on the
normal capacity. Since the fixed overhead is based on the normal capacity, for budgeting
purposes only, the standard fixed overhead rate is constant.
Total variable costs change in relation to the level of production while unit variable cost is
constant.
Budgeted variable overhead Budgeted production x Std. Var. OH per unit) x
Budgeted fixed overhead (Normal capacity x Std. Fixed OH rate/unit) x
Budgeted total overhead Px

Course Module
The Budgeted Statement of Cash Flows
Cash may be considered as the alpha and omega of the business process. Investors’ interest
would boil down to the ability of the business to return their money and how much more
could be given to them as premium for accepting the risk of investing in the business.
Managers are also interested in the daily and regular cash position of the business to
effectively monitor operating activities. An analysis of cash inflows and outflows would
provide management vital information on the liquidity needs of the business. Several
models of cash management, presentation and analyses are presented as follows:
Model 1 – The Working Capital Management Model
Cash balance - beg Px
Add: Cash receipts x
Total cash for use x
Less: Cash payments x
Cash balance before financing x
± Financing cash x
Cash balance - end Px

Model 2 – The Economic Cash Flow Model

Cash inflows Px
Less: Cash outflows x
Net cash inflows (ouflows) x
Add: cash balance - beg x
Cash balance - end Px

Model 3 – The Accounting Model

Cash from operating activities
Cash inflows from operating activities x
Cash outflows from operating activities x Px
Cash from investing activities
Cash inflows from investing activities x
Cash outflows from investing activities x x
Cash from financing activities
Cash inflows from financing activities x
Cash outflows from financing activities x x
Net change in cash and cash equivalents Px

Cash flows are classified as financing, investing, and operating activities. This classification
may be traced from understanding the general contents of the Statement of Financial
Position and Statement of Profit or Loss.
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Budgeting

Statement of Financial Position

INVESTING ACTIVITIES FINANCING ACTIVITIES
Inflows Outflows Inflow Outflows
Sale of Noncurrent √ s
assets Long-term borrowing √
Acquisition of √ Payment of long-term √
noncurrent assets debt
Issuance of shares of √
stock
Retirement of shares of √
stock
Purchase of treasury √
stock
Re-issuance of treasury √
stock
Dividends paid √

Statement of Profit or Loss

OPERATING ACTIVITIES
Inflows Outflows
Cash sales √
Collections from credit customers √
Receipts from other revenue √
Cash purchases √
Payments to merchandise suppliers √
Payments to operating expenses √
Payments to other expenses √

Operating activities employ current assets and current liabilities. The difference of current
assets and current liabilities is called the working capital. It is the fundamental resource
used by the management in generating revenues, costs and profit. As such current items
pertain to operating activities and are excluded from financing and investing activities.
Investing activities basically refer to long-term investments and short-term investments in
financial instrument. Financing activities essentially relate to long-term debt and equity
transactions.
Under the International Financial Reporting Standards, specifically in International
Accounting Standard No. 7, interest expense may be classified as operating or investing
activities depending on the reason of its incurrence. Accordingly, if interest expense is
incurred to sustain the operating activities of the business, such interest is classified as an
operating item. If an interest is incurred arising from the raising of financing money, such
interest is classified as a financing item.

Course Module
 Dividend income may be classified as either operating or investing activity depending on
the nature of the investment from which the dividend is derived and the purpose of
dividend distribution.

Schedule of Accounts Receivable Collections

Credit sales are collected over a period of time. Collection patterns are to be established to
more accurately estimate the inflows of cash from operations. A schedule of Accounts
Receivable collections from credit sales is to be done. Total collections from receivables
include those from credit customers and cash sales.

Schedule of Accounts Payable Payments

Credit purchases are not usually paid in the month of purchase. Normally payments are
spread over a number of months. A schedule of accounts payable payments is to be made to
more accurately determine timing of cash outflows to merchandise suppliers.

Accruals and Prepayments

These are also accrued and prepaid (deferred) income and expenses. In the budgeted
statement of cash flows, only the cash portion of the accrued and prepaid items are
considered. In determining the amount of expenses paid, let us revisit the contents of the
accrued expenses and prepaid expenses accounts, as shown below:
Accrued Expenses

PAID x Beg. Bal. x

End. Bal. x INCURRED x

Prepaid Expenses

Beg. Bal. x INCURRED x

PAID x End. Bal. x

Therefore, expenses paid would be computed as:

Operating expenses incurred Px
Add: Accrued expenses, beg. x
Prepaid expenses, end. x x
Total Px
Less: Accrued expenses, end x
Prepaid expenses, beg. x x
Operating expenses paid Px
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Budgeting

In determining the income received, let us revisit the contents of accrued income and
prepaid income accounts, as shown below:

Accrued Income

Beg. Bal. x RECEIVED x

EARNED x End. Bal. x

Prepaid Income

EARNED x Beg. Bal. x

End. Bal. x RECEIVED x

Therefore, income received is computed as follows:

Income earned Px
Add: Accrued income, beg. x
Unearned income, end. x x
Total Px
Less: Accrued income, end x
Unearned income, beg. x x
Income received Px

Operating Expenses
Operating expenses budget should also be estimated in details. Operating expenses are
classified traditionally as selling expenses and administrative expenses. Operating
expenses could also be classified based on the new model of business functions such as
design engineering expenses, marketing expenses, distribution expenses, and customer
services expenses. The production costs are assembled, grouped and reported as part of
the cost of goods manufactured and sold.

Research and Development

Companies which play leading roles in their industries or line of business, or companies
that operate in a technology-based business environment need to allocate resources for
research and development to stay competitive and relevant in their services to customers.

Course Module
 Detailed research and development budget would provide important information to
managers in their strategic and tactical decisions.
Research has at least three phases: basic research, applied research, and developmental
research. These researches are focused towards cost reduction, product improvements and
development of new products. Distribution as to the overall budget allotment to these
research phases and focuses should be clearly projected, summarized and presented.

Budgeting Models
There are several budgeting models used by organizations. Some examples are flexible
budgeting, fixed (or static) budgeting, continuous budgeting, zero-based budgeting, life-
cycle budgeting, activity-based budgeting, kaizen budgeting, and governmental budgeting.
Flexible budgeting separates costs as to either variable or fixed. In this model, budgeted
costs are determined in any level of business activity. Flexible budgeting uses standard
costs to prepare budgets for multiple activity levels. Total fixed costs remain constant while
total variable costs increase as production level increases. The budgeted costs based on
actual level of production become the standard costs and are compared with the actual
costs to get and analyze costs variances.

Illustration: Flexible Budgeting

The JKL Corporation has a unit direct materials cost of P10, unit direct labor cost of P5, unit
variable overhead cost of P4, factory rent paid of P200,000, factory depreciation of
P400,000, and miscellaneous fixed overhead of P100,000. The company’s normal capacity,
which is also its maximum capacity, is 20,000 units. The budgeted costs at 70%, 80%, 90%,
and 100% capacity are as follows:
Capacity utilization rate 70% 80% 90% 100%
Levels of capacity in units 14,000 16,000 18,000 20,000
Variable Costs: Rate/unit
Direct materials P10 P140,000 P160,000 P180,000 P200,000
Direct labor 5 70,000 80,000 90,000 100,000
Variable 4 56,000 64,000 72,000 80,000
overhead
Sub-total P19 266,000 304,000 342,000 380,000
Fixed costs
Rent P200,000 P200,000 P200,000 P200,000 P200,000
Depreciation 400,000 400,000 400,000 400,000 400,000
Miscellaneous 100,000 100,000 100,000 100,000 100,000
Sub-total 700,000 P700,000 P700,000 P700,000 P700,000
Budgeted Production Costs P966,000 P1,004,000 P1,042,000 P1,080,000
There are several observations that we need to emphasize here:
 The costs rates are defined in their constant expression. Variable cost is constant
per unit while fixed cost is constant per total.
 Total variable cost changes in relation with the change in capacity levels while
total fixed costs remain unchanged.
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Budgeting

Fixed or static budgeting does not segregate costs into fixed and variable components.
Costs are estimated only at a single level of activity. Actual costs are compared with the
budgeted costs regardless of the actual level of production and costs variances are obtained
and analyzed accordingly.
Continuous or rolling budgeting maintains a particular time frame (or period) covered in
budgeting (say 12 months). When a time segment (e.g., month) had passed, it is dropped
from the budget frame and a new month is added to maintain a given time covered by the
budget.
Zero-based budgeting does not consider the past performances in anticipating the future.
Incoming costs should be classified and packaged based on activities which must be
prioritized and justified as to their incurrence. The objective is to encourage examination of
all costs in the hope that costs could be better controlled. ZBB starts from the lowest
budgetary units of the organization. It needs determination of objectives, operations, and
costs for each activity and the alternative means of carrying out that activity. Different
levels of service or work efforts are evaluated for each activity, measurements and
performance standards are established, and activities are ranked according to their
importance to the activity. A decision package is prepared that describes various levels of
service that may be provided, including at least one level lower than the current one. Each
expenditure is justified for each budget period and cost are reviewed from a cost-benefit
perspective.
Life-cycle budgeting intends to account for all costs incurred in the stages of the “value
chain,” from research and development to design, production, marketing, distribution up to
customer service. Costing in this model is important for pricing decisions. Revenues
generated from the product should cover not only the costs of production but the entire
business costs incurred. It is also analyzed in line with the product life-cycle concept where
products have four life stages such as infancy (or start-up stage), growth stage, expansion
stage and maturity (or decline) stage. It is estimated that about 80% of all costs are already
committed (may not be incurred) before the business begins. Life-cycle budgeting
emphasizes the potential for locking in (designing in) future costs since the opportunity of
reducing costs is greater before production begins. In a whole-life costs concept, the budget
includes the “after-purchase costs” closely associated with the life-cycle costs. After-
purchase costs include the costs of operating, support, repair, and disposal incurred by
customers. Whole-life cost equals the life-cycle costs plus the after-purchase costs. Life-
cycle costing is related to target costing and target pricing. A target price is determined in a
given market condition and costs and profit margin are adjusted accordingly.
Activity-based budgeting is applied when the activity-based costing system is used. It
breaks down processes into activities and permits the identification of value-adding
activities and their cost drivers. Activities are grouped according to their homogeneity and
cost drivers are established per homogeneous pool. It tracks down cost incurrence based
on the behavior of its cost driver such as number of set-ups, downtime, number of units

Course Module
 produced, machine hours, number of employees, square footage, number of kilowatts used,
number of customer complaints, and many more.
Kaizen (continuous improvement) budgeting assumes the continuous improvement of
products or processes by way of small innovations rather than major changes. Budgets ae
normally not reached unless innovative improvements occur. Kaizen budgeting is based on
learning curve theory where cost decreases s time passes by and experiences are gained.
Kaizen is also related to product life-cycle costing.
Governmental budgeting is not only a financial plan but is also an expression of public
policy and a form of control having the force of law. A government budget is a legal
document which must be complied with by a government agency head. Since government
budgeting is not profit-oriented, the use of budgets in the appropriation process is of major
importance. One budgeting concept in government budgeting is “line budgeting” where the
emphasis is more on the control of expenditures. Each line expense should be disbursed
according to the limits of the approved appropriations.

References and Supplementary Materials

Books and Journals
1. Rodelio S. Roque (2016). Management Advisory Services. CM Recto, Manila. GIC
Enterprises and Co., Inc.
2. Leonardo E. Aliling, Ma. Flordeliza L. Anastacio (2015). Management Accounting 1.
856 Nicanor Reyes, Sr. St., CM Recto Avenue, Manila. Rex Book Store, Inc.
3. Franklin T. Agamata (2019). Management Services. Certs Publications. Agdao, Davao
City, Philippines
4. Ray H. Garrison, Eric W. Noreen, Peter C. Brewer, 16 th ed. Managerial Accounting. The
McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York

Online Supplementary Reading Materials

1. https://people.ucsc.edu/~shep/migrated/110/110OVR/malory/chap009.ppt
2. https://nptel.ac.in/content/storage2/courses/110101004/downloads/Lecture
%20Notes/module14/lec1.pdf
3. https://www.academia.edu/7966499/Chapter-27-Budgeting-and-Budgetary-
Control_1_
4. https://www.a4efoundation.org/slides/1_financial_planning_and_budgeting.pdf
5. http://cec.nic.in/wpresources/module/Commerce/III_Year/74/e-con
%20652%20transcript.pdf