Chapter 4 Ppts

Strategic Cost Management
Accounting 044
FUNCTIONAL AND ACTIVITY-
BASED BUDGETING
Learning Objectives
Define budgeting and other related terminologies.
Describe the functions, purposes, advantages and
limitations of budgeting.
Distinguish between an operating budget, financial
budget and capital budget.
Explain the management process of preparing the
master budget.
Prepare a sales budget including a computation of
expect cash receipts.
Learning Objectives
Prepare a production budget, direct materials budget,
direct labor budget including a computation of
expected cash disbursement for purchases of material
and payment of direct labor.
Prepare a manufacturing overhead budget and a
selling and administrative expenses budget.
Prepare a cash budget.
Prepare a budgeted income statement and a budgeted
statement of financial position.
Compare fixed and flexible variances.
Budget Defined
Budget - is a functional plan of the resources needed to
carry out task and meet financial goals.
It is also a quantitative expression of the goals the

organization wishes to achieve and the cost of
attaining these goals.
Budget Defined
Budgeting – is the act of preparing a budget.
Master Budget – is a summary of all phases of a

company’s plan and goals in the future. In short, it
represents a comprehensive expression of
management’s plans for the future and how these
plans are to be accomplished.
Planning VS Control
Planning – involves developing objectives and
preparing various budgets to achieve these objectives.
Control – involves the steps taken by the management

to ensure that the objectives set down at the planning
stage are attained and to ensure that all parts of the
organization function in a manner consistent with
organizational policies.
Function of Budgeting
The objective of budgeting is to substitute deliberate,
well-conceived business judgment for accidental
success in enterprise management.
Budget should not be expression of wishful thinking but

rather descriptions of attainable objectives.
Purpose of the Budget
1. Defining broad objectives and goals and formulating
strategies achieve such objectives;
2. Coordinating the activities of the organization by integrating

time plans of the various parts thereby pulling every one in
the same direction;
3. Allocating resources to those parts of the organization where

it can be used most effectively;
Purposes of the Budget
4. Communicating management approved plan
throughout the organization;
5. Uncovering and preparing for potential bottleneck in

the operation before they occur;
6. Motivating managers to achieve the desired result;
7. Setting a standard or benchmark for evaluating actual

performance.
1. Planning Function
a. Strategic planning – which focuses on long-range
horizon and is performed by the highest level of
management.
b. Programming or intermediate range planning –

which involves identification of broad programs in the
functional areas such as marketing plan, a finance plan
and a production plan.
c. Short term budget – which a quantitative detailed

plan covering typically one year established by all
managers at all level.
2. Coordination and Allocation
Budget serves as a tool through which the actions of
different parts of an organization can be welded into a
harmonious unit working toward a common objective.
Good governance is the term used to refer to a firm’s

string to achieve to a common set of objectives.
Budgeting will reconcile the difference between the

sales, manufacturing, purchasing, finance and personnel
department for the common good of an organizational
system. Limited resources will also be properly allocated
for optimum returns.
3. Communication Function
Organization to be efficient must have a definite
lines of communication, so that all employees in
various department can be fully informed of
objectives, policies, plans and achievements.
To a certain extent the employees can gain

understanding of how they can positively contribute
toward accomplishing organizational goals.
4. Motivation Function
Budgeting can be a force for good and evil.
If the budget is dictated from above by top

management and poses a threat to the employees,
then it become something to be resisted rather than
accepted.
Self-imposed budget or participative budget – is

generally considered to be the most effective method
of budget preparation.
5. Control Function
a. Flexibility – which means that the budget is viewed
as a plan, not set in concrete.
b. Focus on controllable cost – managers should be
evaluated only on controllable cost over which they
have “signified influence”.
c. Non-punitive approach – the focus of analysis
should not be solely on unfavorable variances as a
punitive device to make sure that managers do not go
over budget.
6. Standards in Evaluating Performance
Budget should be used as a positive instrument to assist

in establishing goals, in measuring operating results
and in isolating areas that are in need of extra effort or
attention.
The ultimate objective must be to develop the

realization that the budget is designed to be a positive
aid in achieving both individual and company goals.
Advantages of Budgets
1. It forces planning and exposes situations in which plans
of subcomponents are inadequate to attain the total
organization’s objective.
2. It allows a reiterative process to bring the goals of the

organization and the subcomponents into agreement.
3. It provides a means of communicating organization

goals down through the organization and sub-unit
operational limitations up through the organization.
Advantages of Budgets
4. It provides a basis for financial planning, sub-unit
coordination, resource acquisition, inventory policy,
scheduling and output distribution.
5. It provides a basis by which activity can be monitored,

which actual results being compared to the planned
results.
Limitations of Budgets
1. Budget tend to oversimplify the real situation and fail to
allow for variation in external factors. They do not reflect
qualitative variables.
2. It is difficult to prepare a detailed budget for an

organization that has never existed or for a new division,
product or department of an existing firm.
3. There may be lack of higher and lower management

commitment because of lack of understanding of the
fundamentals of budget preparation and utilization.
Limitations of Budgets
4. The budget is only a representation of future plans or
a means to the goal of profitable activity and not end
in itself. It may interfere with the supervisor’s style of
leadership and can therefore stifle initiative.
5. Budget reports usually emphasize results, not reasons.

Types of Budget
The type of budgets or the major composition of the
master budget are:
1) The Operating budget

2) The Financial budget
3) The Capital budget
Sub-classification of budget
Operating Budget
1. Budgeted Income Statement
2. Cost of Sales budget
3. Selling and administrative expenses budget
4. Financial expense budget
Financial Budget
1. Budgeted Statement of Financial Position
2. Cash budget
Capital Investment Budget

Production Budget
Sub-classification
1. Material cost budget

2. Direct labor cost budget
3. Factory overhead budget
4. Inventory level
Budgeting Terminologies
Budgeted Income Statement – refer to projection of
revenue, expenses and result of operations for a
definite period of time.
Cash Budget – a period by period statement of cash at

the start of a budget period, expected cash receipts,
classified by source; expected cash disbursement,
classified by function, responsibility and forms; and
the resulting cash balance at the end of the budget
period.
Financial Budget – refers to the budget of the financial
resources as reflected in the budgeted statement of
financial position and cash budget.
Fixed Budget – projection of cost at a particular or one level

of production (usually at normal capacity) for a definite
time period.
Flexible (variable) Budget – projection of cost at different

levels of production for a definite period of time.
Participative Budget – budget prepared using
employees at all level in the organization.
Physical Budget- budget that is expressed in units of

materials, number of employees, or number of man-
hours or service units rather than in pesos.
Planning Budget (Static Budget) – another term for

master budget.
Production Budget –production plan of resources needed
to meet current sales demand and ensure adequate
inventory levels.
Program Budget – budget for the major programs or

projects that the company plans to undertake.
Operating Budget – refer to plans for the conduct of

business for the planning period; it include the budgeted
income statement and all its supporting budgets.
Responsibility Budget – budget for a responsibility
center.
Rolling (Continuous, progressive) Budget - budget

which is prepared throughout the year, that is, as one
month elapse, a budget is prepared for one month in
the future.
Sales Budget – budget that shows the quantity of each

product and the revenue expected to be sold.
Traditional Budgeting - a system of budgeting which
concentrates on the incremental change from the previous year
assuming that the previous year’s activities are essential and
must be continued.
Zero- based Budgeting – a system of establishing financial plans

beginning with an assumption of no activity and justifying each
program or activity level.
Incremental Budgeting - budget is formulated based on the

previous year’s budget, which is adjusted for any variances
experienced in the past.
Process of Preparing Master Budget
Organization for Budget Preparations – it is
essential that the manager of an entity assigns the
most qualified personnel to the preparation of the
budget.
The Budget Period – as a general rule, the period

covered by a budget should be long enough to show
the effect of managerial policies but short enough so
that estimates can be made with reasonable accuracy.
Master Budget Interrelationship
Steps in Developing a Master Budget
1. Establish basic goals and long-range plans for the
company. These will serve as guidelines in the
preparation of budget estimates.
2. Prepare a sales forecast for the budget period.
3. Estimate the cost of goods sold and operating expenses.
4. Determine the effect of budgeted operating results on
assets, liabilities and ownership equity accounts.
5. Summarize the estimated data in the form of a
projected income statement and statement of financial
position for the budget period.
Static/Fixed Budget
Characteristic of static/fixed budget:
1. It is geared toward only one level of activity.
2. Actual results are always compared against budgeted
costs as the original budget activity level.
 Fixed budget is appropriate only if a company can

estimate its operating volume within close limit and
if the costs are behaving predictably.
Sales Budget
The sales budget showing what product will be sold in what
quantities at what prices, is the foundation on which all
other short term budget are built.
The sales budget triggers a chain reaction that leads to the

development of many other budget figures in an
organization.
The sales budget provide the revenue prediction from

which cash receipts from customer can be estimated and
supplies the basic data for constructing budget for
production cost and selling and administrative expenses.
Factors Affecting Sales Forecast
1. Past sales volume
2. General economic and industry conditions
3. Relationship of sales to economic indicator
4. Relative product profitability
5. Market research studies and competition
6. Pricing, advertising and other promotion policies
7. Production capacity
8. Quality of sales force
9. Seasonal variations
10. Long-term sales trends for various product
The production budget is the key factor in the
determination of other budgets, including the direct
materials budget, the direct labor budget and the
manufacturing overhead budget.
These budgets related to production budget is in turn

are needed to assist in formulating a cash budget.
Raw Materials Budget
The materials budget is used to plan how much raw
materials we need to have available to meet budgeted
production.
This budget is prepare similarly to the

production budget as the company must decide how
much raw materials inventory they want to have on
hand at the end of each quarter.
Direct Labor Budget
The direct labor budget is used to calculate the number of
labor hours that will be needed to produce the units
itemized in the production budget.
The direct labor budget is useful for anticipating the

number of employees who will be needed to staff the
manufacturing area throughout the budget period.
The budget provides information at an aggregate level, and

so is not typically used for specific hiring and layoff
requirements.
Overhead Cost Budget
A manufacturing overhead budget contains all
the costs, other than raw materials and labor, that will
be incurred by a manufacturing company or
department during a fiscal year. These
ongoing costs are a valid part of manufacturing
expenses you incur and should be calculated as part of
your manufacturing budget.
Budgeted Cost of Sales
The cost of goods sold (COGS) budget is essentially
part of your operating budget. COGS is the
direct expense or cost of the production for
the goods sold by a business.
These expenses include the costs of raw material and

labor but do not include indirect costs such as that of
employing a salesperson.
Marketing and Administrative Budget
The selling and administrative budget is comprised of the
budgets of all non-manufacturing departments, such as the
sales, marketing, accounting, engineering, and facilities
departments.
The budget is typically presented in either a monthly or

quarterly format.
It may also be split up into segments for a separate sales

and marketing budget and a separate administration
budget.
Cash Budget
A cash budget is a budget or plan of
expected cash receipts and disbursements during the
period.
These cash inflows and outflows include revenues

collected, expenses paid, and loans receipts and
payments.
In other words, a cash budget is an estimated

projection of the company's cash position in the future.
Budgeted Income Statement
An income statement for a business reports its
earnings and expenses for a given period of time,
typically by the month, quarter or year.
A budgeted income statement is simply a

predicted income statement for a future period of
time, and is also called a pro forma income
statement.
Budgeted Statement of Financial Position
A budgeted statement of financial position is a report

that management uses to predict the levels of assets,
liabilities, and equity based on the budget for the
current accounting period.
Preparing this report is usually the last step in

finalizing a master budget plan.
Flexible Budget
A flexible budget is an alternative to the fixed budget.
A flexible budget adjusts revenues, costs and expenses

to the actual volume experienced and compares these
amounts to actual results.
Flexible budgets incorporate changes in volume to

provide a valid basis of comparison with actual costs.
The End
Financial Ratio Analysis
Financial ratio is a comparison in fraction,

proportion, decimal or percentages form of two
significant figures taken from financial statements.
It expresses the direct relationship between two or

more qualities in the statement of financial position
and income statement of a business firm.
Formula and Significance of Ratio
Current Ratio
Primary test of solvency to meet current obligations

from current assets as a going concern; measure of
adequacy of working capital
Formula
Total Current Assets
Total Current Liabilities
Acid test ratio or Quick ratio
A more severe test of immediate solvency; test of

ability to meet demands from current assets
excluding inventories
Formula
Total Current Assets – Inventories
Total Current Liabilities
Working capital to total assets
Indicate relative liquidity of total assets and

distribution of resources employed
Formula
Working Capital
Total assets
Cash Flow Liquidity Ratio
Measure short-term liquidity by considering cash

resources (numerator) cash plus cash equivalent plus
cash flow from operating activities
Formula
Cash + Marketable Securities+ Cash Flow/Operating
Current Liabilities
Defensive Interval Ratio
Measures length of time in days the firm can operate

on its present liquid resources
Formula
Quick Assets
Projected Daily Operational Expenses
Trade receivable ratio
Velocity of collection of trade accounts and notes; test

of efficiency of collection
Formula
Net credit Sales
Average Trade Receivable
Average Collection Period/Days sales uncollected
Evaluate the liquidity of accounts receivable and the firms

credit policies
Formula
360 days
Receivable turn-over
Account Receivables
Net Sales / 360
Merchandise Turnover
Measure efficiency of the firm in managing and selling

inventories
Formula
Cost of good sold
Average Merchandise Inventory
Finished Goods Inventory
Measures efficiency of the firm in managing and

selling inventories
Formula
Cost of goods sold
Average Finished goods Inventory
Goods in process turnover
Measure efficiency of the firm in managing and selling

inventories
Formula
Cost of goods manufactured
Average goods in process Inventory
Raw material turnover
Number of times raw material inventory was used and

replenished during the period
Formula
Raw Materials Used
Average Raw Material Inventory
Days supply in inventory
Measures average number of days to sell or consume

the average inventory
Formula
360 days
Inventory Turnover
Working Capital Turnover
Indicates adequacy and activity of working capital
Formula
Net Sales
Average Working Capital
Percent of each current assets to total current assets
Indicates relative investment in each current asset
Formula
Amount of each current asset item
Total Current Assets
Current assets turnover
Measure movement and utilization of current

resources to meet operating requirements
Formula
Cost of sales + Operating exp + other expenses
Average current assets
Payable turnover
Measure efficiency of the company in meeting trade

payables
Formula
Net Purchases
Average Account Payables
Operating Cycle
Measures the length of time required to convert cash

to finished goods; then to receivable and then back to
cash
Formula
Inventory turnover + Payable turnover + Day Cash
Days Cash
Measures availability of cash to meet average daily

cash requirement
Formula
Average Cash Balance
Cash Operating Cost/360 days
Free Cash Flow
Excess of operating cash flow over basic needs
Formula
Net Cash from operating activities - Cash used in investing
activities and Dividends
Assets turnover or investment
Measures efficiency of the firm in managing all assets
Formula
Net Sales
Average Total Assets/Investment
Sales to fixed assets / Plant asset turnover
Test roughly the efficiency of management in keeping

plant properties employed
Formula
Net Sales
Average Fixed Assets
Capital intensity ratio
Measures efficiency of the firm to generate sales

through employment of its resources
Formula
Total Assets
Net Sales
Debt ratio
Shows proportion of all assets that are financed with

debt
Formula
Total Liabilities
Total Assets
Equity ratio
Indicates proportion of assets provided by owners.

Reflects financial strength and caution to creditors
Formula
Total Equity
Total Assets
Debt to equity ratio
Measures debt relative to amount of resources

provided by owners
Formula
Total Liabilities
Total Equity
Fixed assets to long term liabilities
Reflects extent of investment in long-term assets

financed from long term debt
Formula
Fixed Assets (net)
Total Long-term Liabilities
Fixed assets to total equity
Measures the proportion of owner’s capital invested in

fixed assets. Measure investment in long-term
capital assets.
Formula
Fixed assets (net)
Total Equity
Fixed Assets to Total Assets
Measure the proportion of fixed assets against total

assets of the company.
Formula
Fixed Assets (net)
Total Assets
Book value per share of ordinary shares
Measure recoverable amount in the event of

liquidation if assets are realized at their book values
Formula
Ordinary shareholders equity
No. of outstanding ordinary shares
Times Interest Earned
Measures how many times interest expenses is covered

by operating profit
Formula
Net Income b4 Interest and Taxes
Annual Interest Charges
Times preferred dividend requirement earned
Indicate ability to provide dividends for preference

shareholders
Formula
Net Income after Taxes
Preferred Dividends Requirement
Times fixed charges earned
Measures coverage capability more broadly than times

interest earned by including other fixed charges
Formula
Net Income B4 Taxes and Fixed Charges
Fixed charges (Rent+Interest+Sinking Fund payment)
Gross Profit Margin
Measures profit generated after consideration of cost

of product sold
Formula
Gross Profit
Net Sales
Operating Profit Margin
Measures profit generated after consideration of

operating cost
Formula
Operating profit
Net Sales
Net Profit Margin / Return on net sales
Measures profit generated after consideration of all

expenses and revenues
Formula
Net Profit
Net Sales
Cash Flow Margin
Measures ability of the firm to translate sales to cash
Formula
Cash Flow for operating activities
Nest Sales
Rate of return on assets / ROA
Measures overall efficiency of the firm in managing

assets and generating profits
Formula
Net Profit
Average Total Assets OR
Asset Turnover X Net Profit Margin

Rate of return on equity
Measures rate of return on resources provided by

owners
Formula
Net Income
Average Ordinary Equity
Earning per share
Peso return on each ordinary share. Indicative of

ability to pay dividends.
Formula
Net Income – preference dividends
Average ordinary shares outstanding
Price/Earnings ratio
Measures relationship between price of ordinary

shares in the open market and profit earned ona per
share basis
Formula
Market value per share of ordinary share
Earnings per share of ordinary shares
Dividend payout
Shows percentages of earning paid to shareholders
Formula
Dividends per share
Earnings per share
Dividend Yield
Shows the rate earned by shareholders from dividends

relate to current stock
Formula
Annual Dividend per share
Market value per share of ordinary shares
Dividends per share
Shows portion of income distributed to shareholders

on a per share basis
Formula
Dividends paid/declared
Ordinary shares Outstanding
Rate of return on average current assets
Measures the profitability of current assets invested
Formula
Net Income
Average Current Assets
Rate of return per turnover of current assets
Shows profitability of each turnover of current assets
Formula
Rate of return on average current assets
Current assets turnover
Chapter 5
The End

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Strategic Cost Management

It is also a quantitative expression of the goals the

Master Budget – is a summary of all phases of a

Control – involves the steps taken by the management

Budget should not be expression of wishful thinking but

2. Coordinating the activities of the organization by integrating

3. Allocating resources to those parts of the organization where

5. Uncovering and preparing for potential bottleneck in

6. Motivating managers to achieve the desired result;

7. Setting a standard or benchmark for evaluating actual

b. Programming or intermediate range planning –

c. Short term budget – which a quantitative detailed

Good governance is the term used to refer to a firm’s

Budgeting will reconcile the difference between the

To a certain extent the employees can gain

If the budget is dictated from above by top

Self-imposed budget or participative budget – is

Budget should be used as a positive instrument to assist

The ultimate objective must be to develop the

2. It allows a reiterative process to bring the goals of the

3. It provides a means of communicating organization

5. It provides a basis by which activity can be monitored,

2. It is difficult to prepare a detailed budget for an

3. There may be lack of higher and lower management

5. Budget reports usually emphasize results, not reasons.

1) The Operating budget

Capital Investment Budget

1. Material cost budget

Cash Budget – a period by period statement of cash at

Fixed Budget – projection of cost at a particular or one level

Flexible (variable) Budget – projection of cost at different

Physical Budget- budget that is expressed in units of

Planning Budget (Static Budget) – another term for

Program Budget – budget for the major programs or

Operating Budget – refer to plans for the conduct of

Rolling (Continuous, progressive) Budget - budget

Sales Budget – budget that shows the quantity of each

Zero- based Budgeting – a system of establishing financial plans

Incremental Budgeting - budget is formulated based on the

The Budget Period – as a general rule, the period

 Fixed budget is appropriate only if a company can

The sales budget triggers a chain reaction that leads to the

The sales budget provide the revenue prediction from

These budgets related to production budget is in turn

This budget is prepare similarly to the

The direct labor budget is useful for anticipating the

The budget provides information at an aggregate level, and

These expenses include the costs of raw material and

The budget is typically presented in either a monthly or

It may also be split up into segments for a separate sales

These cash inflows and outflows include revenues

In other words, a cash budget is an estimated

A budgeted income statement is simply a

A budgeted statement of financial position is a report

Preparing this report is usually the last step in

A flexible budget adjusts revenues, costs and expenses

Flexible budgets incorporate changes in volume to

Financial ratio is a comparison in fraction,

It expresses the direct relationship between two or

Primary test of solvency to meet current obligations

Acid test ratio or Quick ratio

A more severe test of immediate solvency; test of

Working capital to total assets

Indicate relative liquidity of total assets and