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Budgeting and Profit

Planning
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BUDGETING AND PROFIT


PLANNING

Planning Process
Budget-Definition, Meaning
and Purpose
Preparation/Types of Budgets
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Planning Process
Budgeting is a tool of planning. Planning involves specification of
the basic objectives that the organisation will pursue and the
fundamental policies that will guide it. In operational terms,
it involves four steps:
(1) Objectives
Objectives are broad and long-range desired state or position in future.
(2) Goals
Goals are quantitative targets to be achieved in specified period.
(3) Strategies
Strategies represent specific course of action to achieve goals.
(4) Plans
The final step is the preparation of budgets/profit plans. It converts goals
and strategies into annual operating plans.
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Budget
A budget is defined as a comprehensive and coordinated plan,
expressed in financial terms, for the operations and resources
of an enterprise for some specified period in the future.
The essential elements of a budget are:

(1) Plan
(2) Financial terms
(3) Operations and resources
(4) Specific future period
(5) Comprehensive coverage
(6) Coordination
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1. Plan
The first ingredient of a budget is its plan. It includes two aspects which
have a bearing on the operations of an enterprise. One set of factors, which
determine a firms future operations are wholly external and beyond its
control. The second set of factors affecting future activities are within the
firms control and discretion, that is, they are internal.

2. Operations and Resources


A budget is a mechanism to plan for the firms operations and resources.
The operations are reflected in revenues and expenses.
The plan also covers the resources of the firm. The planning of resources
means the planning of the various assets and the sources of capital to
finance these assets. The assets could be fixed assets as well as current
assets.

3. Financial Terms
Budgets are prepared in financial terms, that is, in terms of monetary value
such as the rupee, dollar, and so on. The reason is that the monetary unit is
a common denominator.
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4. Specified Future Period


A budget relates to a specified period of time, usually one year.
5. Comprehensiveness
A budget is comprehensive in that all the activities and operations of
an organisation are included in it. It covers the organisation as a
whole and not only some segments. The modus operandi is that
budgets are prepared for each segment/facet/activity/division of an
organisation.
6. Coordination
Budgets
are
prepared
for
the
different
components/
segments/divisions/ facets/activities of an organisation so as to take
care of the situations and problems of each component. The
budgets for each of the components are prepared in harmony with
each another. This is called coordination.

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Budget Purpose
The main objectives of budgeting are:
1. Explicit statement of expectations
2. Communication
3. Coordination,
4. Expectations as a framework for judging performance
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1. Explicit Statement of Expectations


One purpose of budgeting is to state expectations in formal terms so that
most of the underlying assumptions may be identified. A firm has the
basic objective of optimising long-run profit. Its long-range goals
also include survival, consumer satisfaction, employee
welfare, personal power and prestige, and so on.
However, a budget does not lay down a statement of expectations in rigid
terms. A budget should be modified when necessary in the light of
the changes in the factors/assumptions on which the
original estimates were based.

2. Communication
Another purpose of budgeting is to communicate or inform others of the
goals and methods selected by top management. Since budgeting
deals with fundamental policies and objectives, it is
prepared by top management.

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3. Coordination
Yet another purpose of budgeting is coordination. The term coordination
refers to the operation of all departments of an organisation in
such a way that there is no bottleneck or imbalance.
In view of the above, coordination is a major function of budgeting.
Budgets should be drafted in such a way that the operations
of the various departments are related to each other for
the achievement of the overall goal.

4. Expectations as a Framework for Judging Performance


Finally, a budget establishes expectations as a framework for judging
employee performance.

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TYPES OF BUDGETS
The overall budget is known as the master budge. A
master budget normally consists of three
types of budgets:

(i) Operating
Operating Budgets
Budgets
(i)
(ii) Financial
Financial Budgets
Budgets
(ii)
(iii) Special
Special Decision
Decision Budgets
Budgets
(iii)
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1. Operating Budget
Operating budgets relate to physical activities/
operations such as sales, production,
and so on.
Operating budget has the following components
1)
2)
3)
4)
5)
6)

Sales budget,
Production budget,
Purchase budget,
Direct labour budget,
Manufacturing expenses budget, and
Administrative and selling expenses budget, and
so on.
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2. Financial Budget
Financial budgets are concerned with expected
cash flows, financial position and
result of operations.
Financial budget has the following components
1)
2)
3)
4)

Budgeted income statement,


Budgeted statement of retained earnings,
Cash budget, and
Budgeted balance sheet.
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Cash Budget
Cash budget is a device to help a firm to plan for and control the use of
cash. It is a statement showing the estimated cash inflows and cash
outflows over the planning period. The principal aim of the cash
budget, as a tool to predict cash flows over a period of time,
is to ascertain whether there is likely to be excess/shortage of cash at any
time.

The preparation of a cash budget involves several steps.


The first element of a cash budget is the selection of the period of
the budget, that is, the planning horizon.
The second element of the cash budget is the selection/identification
of the factors that have a bearing on cash flows.
The factors that generate cash are generally divided into two broad
categories:
(i) Operating

(ii) Financial

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Operating Cash Flow


The main operating factors/items which generate cash
outlfows and inflows over the time span of a
cash budget are tabulated in Exhibit 1.
Exhibit 1. Operating Cash Flow Items
Cash inflows/Receipts

Cash outflows/Disbursements

1.Cash sales
2.Collection of accounts
receivable
3.Disposal of fixed assets

1. Accounts payable/Payable payments


2. Purchase of raw materials
3. Wages and salary (pay roll)
4. Factory expenses
5. Administrative and selling expenses
6. Maintenance expenses
7. Purchase of fixed assets

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Financial Cash Flow Items


The major financial factors/items affecting generation
of cash flows are depicted in Exhibit 2.
Exhibit 2. Financial Cash Flow Items
Cash inflows/Receipts

Cash outflows/Payments

1. Loans/borrowings
2. Sale of securities
3. Interest received
4. Dividend received
5. Rent received
6. Refund of tax
7. Issues of new shares and
securities

1.
2.
3.
4.
5.

Income tax/tax payments


Redemption of loan
Re-purchase of shares
Interest paid
Dividends paid

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Example 1
The following data relate to Hypothetical Limited:
Balance Sheet as at March 31, Current Year
Liabilities

Amount Assets

Accounts payable
(all for March purchases)
Taxes payable
(all for March income)
Share capital
Retained earnings

Rs 40,000
25,000
11,00,000
10,26,800

_______
21,91,800

Cash
Accounts receivable
(all from March sales)
Inventories:
Raw materials (9,600 kgs Rs 3)
Finished goods
(1,800 units Rs 35)
Fixed assets:
Cost
Rs 20,00,000
Less: Accumulated
depreciation
(4,50,000)

Amount
Rs 3,00,000
2,50,000
28,800

63,000

15,50,000
21,91,800

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2. Sales forecasts: Assume the marketing department has developed the


following sales forecast for the first quarter of the next year and the selling
price of Rs 50 per unit.
Month

Units sales

April
May
June

9,000
12,000
16,000

3. The management desires closing inventory to equal 20 per cent of the


following months sales.
4. The manufacturing costs are as follows
Direct materials: (5 kgs Rs 3) (per unit)
Direct labour
Variable overheads
Total fixed overheads (per annum)

Rs 15
5
9
7,20,000

5. Normal capacity is 1,20,000 units per annum. Assume absorption costing


basis.
6. Each unit of final product requires 5 kgs of raw materials. Assume
management desires closing raw material inventory to equal 20 per cent
of the following months requirements of production.
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7. Assume fixed selling and administrative expenses are Rs 20,000 per


month and variable selling and administrative expenses are Rs 5 per
unit sold.
8. All sales are on account. Payment received within 10 days from the date
of sale are subject to a 2 per cent cash discount. In the past, 60 per cent
of the sales were collected during the month of sale and 40 per cent are
collected during the following month. Of collections during the month of
sale, 50 per cent are collected during the discount period. Accounts
receivable are recorded at the gross amount and cash discounts are
treated as a reduction in arriving at net sales during the month they are
taken.
9. Tax rate is 35 per cent.
10. Additional information:
(a) All purchases are on account. Two-thirds are paid for in the month
of purchase and one-third, in the following month.
(b) Fixed manufacturing costs include depreciation of Rs 20,000 per
month.
(c) Taxes are paid in the following month.
(d) All other costs and/or expenses are paid during the month in which
incurred.
From the foregoing information prepare a master budget for the month of
April only.
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Solution
1.Production Budget
Particulars
Sales (units)
Add: Desired closing inventory (0.20 next months sales)
Total finished goods requirement
Less: Opening inventory
Required production (units)

April

May

9,000
2,400
11,400
(1,800)
9,600

12,000
3,200
15,200
(2,400)
12,800

2.Manufacturing Cost Budget


Particulars
Required production (units)
Direct material cost (5 kgs Rs 3 per kg)
Total direct material cost
Total direct labour cost (Rs 5 per unit)
Total variable overhead cost (Rs 9 per unit)
Total variable manufacturing costs
All fixed manufacturing overheads (Rs 7,20,000 12 months)
Total manufacturing cost

April
9,600
Rs 15
Rs 1,44,000
48,000
86,400
2,78,400
60,000
3,38,400

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3.Purchase Budget (Raw Materials)


Particulars

April

Production requirement (units)


9,600
Raw material required for production @ 5 kgs per unit
______
(kgs)
48,000
Add: Desired closing inventory (0.20 May
requirements)
12,800
Total requirements
60,800
Less: Opening inventory
(9,600)
Purchase requirement
51,200
Purchase requirement (amount @ Rs 3 per kg)
Rs 1,53,600

May
12,800
_____
64,000

4.Selling and Administrative Expenses Budget


Particulars
Units sales
Variable costs @ Rs 5 per unit
Fixed costs
Total selling and administrative expenses

April
9,000
Rs 45,000
20,000
65,000

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5. Cost of Goods Sold Budget


Particulars

April

Units sold
Cost per unit
Variable
Fixed (Rs 60,000 10,000 units)
Total cost

9,000
Rs 29
6

Rs 35
3,15,000

6. Budgeted Income Statement for the Month of April


Gross sales (9,000 Rs 50)
Less: Cash discount (Rs 4,50,000 0.6 0.5 0.02)
Net sales
Less: Cost of goods sold
Gross margin (unadjusted)
Less: Capacity variance unfavourable (400 units Rs 6)
Gross margin (adjusted)
Less: Selling and administrative expenses
Earnings before taxes
Less: Taxes (0.35)
Earning after taxes

Rs 4,50,000
2,700
4,47,300
3,15,000
1,32,300
2,400
1,29,900
65,000
64,900
22,715
42,185

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7.Budgeted Statement of Retained Earnings


Opening balance
Add: Earnings after taxes
Closing balance

Rs 10,26,800
42,185
10,68,985

8.Cash Budget (April)


Opening balance
Cash inflows:
Collection from debtors:
March sales
April sales (gross) (Rs 4,50,000
0.60)
Less: Cash discount
(Rs 2,70,000 0.5 0.02)
Cash outflows:
Payment to creditors:
For March purchases
For April purchases (Rs 1,53,600
2/3)
Direct labour
Variable manufacturing overhead
Fixed manufacturing overhead
Less: Depreciation
Variable selling and administrative
overheads
Fixed selling and administrative
overheads
Taxes
Closing balance

Rs 3,00,000
Rs 2,50,000
Rs 2,70,000
2,700

2,67,300

5,17,300

Rs 8,17,300

40,000
1,02,400
60,000
(20,000)

1,42,400
48,000
86,400
40,000
45,000
20,000
25,000

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4,06,800
4,10,500

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9. Proforma Balance Sheet as at March 31, Next Year


Liabilities

Amount Assets

Accounts payable
(Rs 40,000 +
Rs 1,53,600
Rs 1,42,400)
Taxes payable
(Rs 25,000 + Rs 22,715
Rs 25,000)
Share capital
Retained earnings

Rs 51,200

22,715
11,00,000
10,68,985

________
22,42,900

Cash
Accounts receivable
(Rs 4,50,000 0.40)
Inventories:
Raw material
(12,800 Rs 3)
Finished goods
(2,400 Rs 35)
Fixed assets:
Cost
Less: Accumulated
depreciation

Amount
Rs 4,10,500
1,80,000

Rs 38,400
84,000

1,22,400

20,00,000
(4,70,000)

15,30,000
22,42,900

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Special Decision Budgets


The third category of budgets are special decision
budgets. They relate to inventory levels, break-even
analysis, and so on.

Fixed and Flexible Budgets


Fixed Budgets
Budgets prepared at a single level of activity, with no prospect of
modification in the light of changed circumstances, are referred to
as fixed budgets.
Flexible Budgets
The alternative to fixed budgets are flexible/variable/sliding
budgets
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Flexible Budgets
The term flexible is an apt description of the essential
features of these budgets. A flexible budget estimates costs
at several levels of activity.
Its merit is that instead of one estimate, it contains several
estimates/plans in different assumed circumstances. It
is a useful tool in real world situations, that is, unpredictable
environment.
A flexible budget, in a sense, is a series of fixed budgets and
any increase/decrease in the level/volume of activity must be
reflected in it.
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The conceptual framework of flexible budgeting relates


to: (i) Measure of volume and (ii) Cost behaviour with
change in volume
Each expense in each department/segment is to be
categorised into fixed, variable and mixed components.
A budget may first be prepared at the expected level of
activity, say, 100 per cent capacity. Additional
columns may then be added for costs below and above,
90 per cent and 110 per cent capacity and so on.

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Table 1 Hypothetical LtdFlexible Budget (Maintenance Department)


Volume (labour-hours)
Variable costs:
Labour
Material
Others
Mixed costs:
Labour
Maintenance
Other supplies
Discretionary fixed costs:
Training
Experimental methods
Committed fixed costs:
Depreciation
Rent, lease cost
Total

4,000

4,500

5,000

5,500

6,000

Rs 6,000
2,400
800

Rs 6,750
2,700
900

Rs 7,500
3,000
1,000

Rs 8,250
3,300
1,100

Rs 9,000
3,600
1,200

2,300
1,400
2,500

2,400
1,450
2,750

2,500
1,500
3,000

2,600
1,550
3,250

2,700
1,600
3,500

1,500
3,500

2,000
4,000

2,000
4,000

2,000
4,000

2,500
4,500

5,000
3,500
28,900

5,000
3,500
31,450

5,000
3,500
33,000

5,000
3,500
34,550

5,000
3,500
37,100

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Table 2: Hypothetical LtdFlexible Budget (Manufacturing Department)


Volume (machine-hours)

50

60

70

80

90

Variable costs:
Power

Rs 500

Rs 600

Rs 700

Rs 800

Rs 900

250

300

350

400

450

Training

800

900

900

900

1,000

Tools

200

200

200

300

300

Depreciation

1,200

1,200

1,200

1,200

1,200

Rent

1,000

1,000

1,000

1,000

1,000

3,950

4,200

4,350

4,600

4,850

Helpers
Discretionary fixed costs:

Committed fixed costs:

Total

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Modified Flexible Budgets


Flexible budgets, as a tool of planning and control, are superior
to fixed budgets.
The major weaknesses of fixed budgets are their inability to:
(i) Show the potential variability of various estimates used in the
preparation of the budget, and
(ii) Indicate the range within which costs may be expected to vary. They
are, therefore, not useful in an uncertain and unpredictable environment.
Flexible budgets present estimates at different levels of activity, and are
more useful.
Limitations
Flexible budgets suffer from one limitation in that they do not explicitly
consider the relative probability of a particular volume/cost being achieved.
This limitation can be overcome by using a modified
flexible budget which will include columns for different levels
of estimates: most likely, optimistic and pessimistic.
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Table 3: Hypothetical
Department)

LtdModified

Flexible

Budget

Pessimistic Most likely


Volume (labour-hours)
Variable costs:
Labour
Materials
Others
Mixed costs:
Labour
Maintenance
Other supplies
Discretionary fixed costs:
Training
Experimental methods
Committed fixed costs:
Depreciation
Rent, etc.
Total

(Manufacturing
Optimistic

4,250

5,000

5,850

Rs 6,375
2,650
850

Rs 7,500
3,000
1,000

Rs 8,775
3,510
1,170

2,350
1,425
2,625

2,500
1,500
3,000

3,425
1,585
2,670

1,750
3,750

2,000
4,000

2,250
4,250

5,000
3,500
30,275

5,000
3,500
33,000

5,000
3,500
36,135

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