Chapter 5:

The Budgeting Process

1) Budgets & the overall planning process
2) Purposes of budgeting
3) Stages in the budget process
4) Functional & Master budgets
5) Activity-based budgeting (ABB)
6) Criticisms of traditional budgeting
1) Budgets & the overall planning process
: The role of long term and short term planning within the
planning; decision making; and control process

1. Identify the objectives of the

organization.

2. Identify potential strategies.

3. Evaluate alternative strategic

options.

4. Select course of action.

5. Implement the long-term plan in

the form of the annual budget.

6. Monitor actual results.

7. Respond to divergencies from

plan.
2) Purposes of budgeting

1. To aid the planning of actual operations:

• by forcing managers to consider how conditions might

change and what steps should be taken now.

• by encouraging managers to consider problems before

they arise.

2. To co-ordinate the activities of the organization:

• by compelling managers to examine relationships

between their own operation and those of other
departments.
Purposes of budgeting

3. To communicate plans to various responsibility centre managers:

• everyone in the organization should have a clear

understanding of the part they are expected to play in
achieving the annual budget.

• by ensuring appropriate individuals are made

accountable for implementing the budget.

4. To motivate managers to strive to achieve the budget goals:

• by focusing on participation

• by providing a challenge/target.
Purposes of budgeting

5. To control activities:

• by comparison of actual with budget (attention

directing/management by exception).

6. To evaluate the performance of managers:

• by providing a means of informing managers of how

well they are performing in meeting targets they
have previously set.
3) Stages in the budget process

1.Communicate details of budget policy and guidelines to those people responsible

for preparing the budget.

2. Determine the factor that restricts output (budget factor).

3. Preparation of the sales budget.

4. Initial preparation of budgets.

5. Negotiation of budgets with higher management.

6. Co-ordination and review of budgets.

7. Final acceptance of budgets.

8. Ongoing review of the budgets.

Stages in the budget process
4) Functional & Master budgets

REFER E.G. 15.1 (pg 379)

Assumption here: Example is based on an annual budget and for

only 2 responsibility centres, Dept 1 & Dept 2.

Functional Budgets
(1) Sales Budget
- shows how many units of a product a company plans to sell at an
intended selling price
- shows how much of total revenue and cash receipts from customers to
be expected
- it provides a basis for which production; selling, distribution and
administrative expenses budgets can be constructed (as all depend on
sales volume)
- hence if the sales budget is not accurate, other budget estimates
cannot be reliable
Functional & Master budgets

Sales Budget for the year ending 200X

Units Selling Total
Products sold price (£) revenue (£)
Alpha 8 500 400 3 400 000
Sigma 1 600 560 896 000
4 296 000
Functional & Master budgets

(2) Production Budget & Budgeted Stock Levels

- next budget is the production budget
- expressed in quantities only
- ensure that production is enough for sales volume and stock levels are
maintained

Annual Production Budget

Dept. 1(alpha) Dept. 2 (sigma)
Units to be sold 8 500 1 600
Planned closing stock 1 870 90
Total units required for sales
and stock 10 370 1 690
Less: planned opening stock 170 85
Units to be produced 10 200 1 605
Functional & Master budgets

(3) Direct Materials Usage Budget

- Based on the production budget, estimates on materials required for
production is prepared

Annual Direct Material Usage Budget

Dept 1 (alpha) Dept 2 (sigma)
Uts Ut Total Uts Ut Total Total Total
price price uts

(£) (£) (£) (£) (£)

Mat.X *102 000 7.20 734 400 12 840 7.20 92 448 114 840 826 848
Mat.Y **51 000 16.00 816 000 14 445 16.00 231 120 65 445 1 047 120
1 550 400 323 568 1 873 968

* 10 200 units x 10 units of X for each unit of alpha

** 10 200 units x 5 units of Y for each unit of alpha
Functional & Master budgets

(4) Direct Materials Purchase Budget

- shows how much of raw material needs to be purchased to meet
production requirements
- need to purchase at the right time and planned purchase price
- planned raw material stock levels need to be taken into account

Direct Materials Purchase Budget

Mat. X Mat.Y
(units) (units)
Quantity necessary to meet production
requirements as per mat.usage budget 114 840 65 445
Planned closing stock 10 200 1 700
125 040 67 145
Less: Planned opening stock 8 500 8 000
Total units to be purchased 116 540 59 145
Planned unit purchase price £7.20 £16.00
Total purchases £839 088 £946 320
Functional & Master budgets

(5) Direct Labour Budget

- shows how much of direct labour hours is needed to meet production
requirement
- labour rate per hour is determined by IR dept.

Annual Direct Labour Budget

Dept 1(alpha) Dept 2 (sigma) Total

Budgeted production (uts) 10 200 1 605
Hours per unit 10 15
Total budgeted hours 102 000 24 075 126 075
Budgeted wage rate per hour £12 £12
Total wages £1 224 000 £288 900 £1 512900
Functional & Master budgets

(6) Factory O/H Budget

- overheads depend on cost behaviour of individual overhead items in
relation to anticipated production levels
- must be analysed in terms of controllable and non-controllable costs
Functional & Master budgets

Annual Factory Overhead Budget

: O/H is recovered on DL hours: Dept 1 – 102 000 DLH; Dept 2 – 24 075 DLH

Variable O/H rate p/DLH Overheads

Dept 1 Dept 2 Dept 1 Dept 2 Total
(£) (£) (£) (£) (£)
Controllable O/H:
Indirect material 1.20 0.80 122 400 19 260
Indirect labour 1.20 1.20 122 400 28 890
Power (variable) 0.60 0.40 61 200 9 630
Maintenance (var.) 0.20 0.40 20 400 9 630
326 400 67 410 393 810

Non-controllable O/H:
Depreciation 100 000 80 000
Supervision 100 000 40 000
Power (fixed) 40 000 2 000
Maintenance (fixed) 45 600 3 196
285 600 125 196 410 796
Total O/H 612 000 192 606 804 606
Budgeted dept. O/H *£6.00 £8.00
Dept. O/H rate = 612 000 / 102 000; 192 606 / 24 075
Functional & Master budgets

(7) Selling & Administration Budget

Annual Selling & Administration Budget

(£) (£)

Selling:
Salaries 74 000
Commission 60 000
Car expenses 22 000
Advertising 80 000 236 000
Administration:
Stationery 4 000
Salaries 28 000
Miscellaneous 8 000 40 000
276 000
Functional & Master budgets

(8) Departmental Budgets

- shows costs according to departments :DL; DM usage & factory o/h

Annual Dept. Operating Budget (Dept 1)

(£) Budget (£) Actual (£)
Direct Labour 1 224 000
Direct Material: X 734 400
:Y 816 000 1 550 400
Controllable O/H:
Indirect Materials 122 400
Indirect Labour 122 400
Power (var.) 61 200
Maintenance (var.) 20 400 326 400
Uncontrollable O/H:
Depreciation 100 000
Supervision 100 000
Power (fixed) 40 000
Maintenance (fixed) 45 600 285 600
3 386 400
Functional & Master budgets

(9) Cash Budget

- to make sure that there is always sufficient cash at al times to fund
operations on a daily basis.
-To make sure that there is more cash than needed in cases of
uncertainty.

Cash Budget for year ending 200X

Qtr. Qtr. Qtr. Qtr. Total
1 2 3 4
(£) (£) (£) (£) (£)
Op.bal. 34 000 114 000 294 000 421 984 34 000
Receipts from
debtors 1 000 0001 200 0001 120 000 985 0004 305 000
1 034 0001 314 0001 414 0001 406 9844 339 000
Payments: Purchase of mat. 400 000 480 000 440 000 547 9841 867 984
Payment of wages 400 000 440 000 480 000 646 1881 966 188
Other costs & exp. 120 000 100 000 72 016 13 642 305 658
920 0001 020 000 992 0161 207 8144 139 830
Closing bal. 114 000 294 000 421 984 199 170 199 170
Functional & Master budgets

(10)Master Budget
- shows the overall budgeted profit and loss account and balance sheet
for the period

Finished good unit cost

Alpha Sigma
(unit) (£) (unit) (£)
DM: X 10 72.00 8 57.60
Y 5 80.00 9 144.00
DL 10 120.00 15 180.00
Factory O/H
: Dept 1 10 60.00 - -
: Dept 2 - - 15 120.00
332.00 501.60
Functional & Master budgets

Budgeted P/L A/C for the year ending 200X

(£) (£) (£)
Sales 4 296 000
Opening Stock of raw materials 189 200
Purchases 1 785 408
1 974 608
Less: Closing stock of raw materials 100 640
Cost of raw material consumed 1 873 968
Direct Labour 1 512 900
Factory o/h 804 606
Total manufacturing cost 4 191 474
Add: opening stock of finished goods 99 076
Less: closing stock of finished goods 665 984
(566 908)
Cost of sales 3 624 566
Gross profit 671 434
Selling & admin exp. 276 000
Budgeted operating profit for the year 395 434
Functional & Master budgets

Budgeted St. of Fin. Pos. as at 31 December 200X

(£) (£)
Non current assets:
Land 170 000
Building & equipment 1 292 000
Less: Depreciation 435 000 857 000
1 027 000
Current Assets:
Raw material stock 100 640
Finished goods stock 665 984
Debtors 280 000
Cash 199 170
1 245 794
Current Liabilities:
Creditors 307 884 937 910
1 964 910
Represented by sh/h interest 1 200 000
Reserves 369 476
Profit & Loss A/C 395 434 1 964 910
5) Activity-based budgeting (ABB)

• Conventional budgeting is inappropriate for those activities where

the consumption of resources does not vary proportionately with the
volume of the final output of products or services.

• For support activities conventional incremental budgets merely

serve as authorization levels for certain levels of spending.

• Incremental budgeting results in the cost of non-unit level activities

becoming fixed.

• ABB however, aims to authorize only the supply of those resources that
are needed to perform activities required to meet budgeted production
and sales volumes.
Activity-based budgeting (ABB)

• The ABB process is the reverse of the ABC process:

Budgeted output of cost objects

Determine the necessary activities

Determine the resources required for the budget period

Activity-based budgeting (ABB)

ABB involves the following stages:

1. Estimate the production and sales volume by individual products and

customers.

2. Estimate the demand for organizational activities.

(e.g.Process 5,000 customers’ orders for the customer order
processing activity)

3. Determine the resources that are required to perform organizational

activities.
(e.g.0.5 hours per order = 5,000 × 0.5 hours =
2,500 labour hours for the customer processing
activity must be supplied)
Activity-based budgeting (ABB)

4. Estimate for each resource the quantity that must be supplied to meet
the demand.

(e.g.Assume a step cost function with each

person employed contracted to work 1,500 hours
per year so that quantity of resources required =
2,500/1,500 =1.67 persons meaning that 2
persons must be employed)

5.Take action to adjust the capacity of resources to match the projected

supply.

(e.g If 3 persons are presently employed on the

activity resources must be reduced,or redeployed,
by one person)
Activity-based budgeting (ABB)

• Periodically actual results should be compared with an adjusted

(flexible)
budget.
Example
Budgeted activity for processing orders = 2,800 orders
Orders processed per person = 600
Resources required = 4.67 persons
Resources supplied
(practical capacity for 3,000 orders) = 5 persons
Employment costs (£25,000 per person per year) = £125,000
Cost driver rate (£125,000/3,000 orders) = £41.67
Actual orders processed for the period = 2,500 orders

Performance report:
Flexed budget (2,500 ×£41.67 ) = £104,175
Budgeted unused capacity (3,000 — 2,800)× £41.67 = 8,334
Unplanned unused capacity (2,800 –2,500)× £41.67 = 12,491
125,000
Activity-based budgeting (ABB)

• Above represent committed resources but for flexible resources

(e.g.office supplies) resources supplied can be matched exactly to
resources demanded.

• See sheet 8 for an illustration of an activity-based budget for an order

processing activity.
Activity-based budgeting (ABB): for an order receiving process
 Reference
Colin Drury, Management and Cost
Accounting, 9th Edition, Cengage Learning
EMEA.
ISBN 978-1-4080-9393-1