Chapter -Three

BUDGETS AND BUDGETARY

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Learning Objectives
 Understand Budget, essentials of effective budgeting
 Understand types of budgets, master budget and the
components of the master budget.
 Prepare budgets for sales, production, and direct materials.
 Prepare budgets for direct labor, manufacturing overhead,
and selling and administrative expenses, and a budgeted
income statement.
 Prepare a cash budget and a budgeted balance sheet.
 Apply budgeting principles to nonmanufacturing
companies.

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 Fundamental concepts of budgeting
Budget is:
A written statement of management’s plans for a
specified future time period, expressed in financial
terms.
It is a predetermined detailed plan of action developed
and distributed as a guide to current operations and as a
partial basis for the subsequent evaluation of performance
Is a short- term financial plan which acts as a guide to
achieve the pre -determined targets.
Budgeting: is the act of preparing a budget

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 Fundamental concepts of budgeting
• Meaning of budget and budgeting:
• CIMA (UK) defined a budget as “A plan quantified in
monetary terms prepared and approved prior to a
defined period of time, usually showing planned
income to be generated and, expenditure to be
incurred during the period and the capital to be
employed to attain a given objective.”
• Other definitions of budget include:
• “a budget is a plan of action to achieve stated
objectives based on predetermined series of related
assumptions.” (Keller & Ferrara )
• “a budget is a written plan covering projected
activities of a firm for a definite time period.”
(G.A.Welsh)
 FUNDAMENTAL CONCEPTS OF BUDGETING

Features of a budget • It is mainly a forecasting and

controlling device.
• It is prepared in advance
before the actual operation of
the company or project.
• It is in connection with a
definite future period.
• Needs approval by
management before
implementation.
• It shows capital to be
employed during the period.
 FUNDAMENTAL CONCEPTS OF BUDGETING

Budget Cycle
• According to Horngren etal (2003), in well managed
companies, a budget cycles in the following steps:
• Planning the performance of the company (as a whole as
well as for its units). Management at all levels agrees on
what is expected
• Providing a frame of reference (a set of specific
expectations against which actual results will be compared)
• Investigating variations from plans to follow corrective
actions, if necessary
• Planning again, in light of feedback and changed conditions
Benefits of Budgeting
 Helps all levels of management to plan ahead

 A primary method of communicating agreed-upon objectives

throughout the organization

 Promotes efficiency

 Control device - important basis for performance evaluation once

adopted

 Provides definite objectives for evaluating performance

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Benefits of Budgeting Cont…
 Creates an early warning system for potential problems

 Facilitates coordination of activities within the business

 Results in greater management awareness of the entity’s overall

operations

 It motivates personnel throughout organization to meet planned

objectives

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Drawbacks of Budgeting

• Budgets are based on assumptions and are not exact.

• External factors, e.g. the economy, make it almost
impossible to set accurate budgets, so could be classed
as time wasting.
• Could be demoralising if set incorrectly.
• Managers take short-term decisions in order to meet
budgetary requirements.

Copyright ©2018 John Wiley & Sons, Inc. 9

Essentials(considerations) of Effective Budgeting

• Depends on a sound organizational structure with

authority and responsibility for all phases of operations
clearly defined

• Based on research and analysis with realistic goals

• Accepted by all levels of management

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Budgeting-Length of the Budget Period
• Budget may be prepared for any period of time
 Most common - one year
 Supplement with monthly and quarterly budgets
 Different budgets may cover different time periods
• Long enough to provide an attainable goal and minimize
seasonal or cyclical fluctuations
• Short enough for reliable estimates

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FUNDAMENTAL CONCEPTS OF BUDGETING

Budgeting and Accounting

• Historical accounting data on revenues, costs, and
expenses help in formulating future budgets
• Accountants normally responsible for presenting
management’s budgeting goals in financial terms
• Budget and its administration are the responsibility of
management

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FUNDAMENTAL CONCEPTS OF BUDGETING

Budgetary Control
• According to CIMA, “Budgetary control is the establishment of
budgets relating to the responsibilities of executives of a policy and
the continuous comparison of the actual with the budgeted results,
either to secure by individual action, the objective of the policy or to
provide a basis for its revision.”
 FUNDAMENTAL CONCEPTS OF BUDGETING
Elements of budgetary control

1. Establishment of budgets for each function and division of the

organization.
2. Regular comparison of the actual performance with the budget
to know the variations from budget and placing the
responsibility of executives to achieve the desire result as
estimated in the budget.
3. Taking necessary remedial action to achieve the desired
objectives, if there is a variation of the actual performance
from the budgeted performance.
4. Revision of budgets when the circumstances change.
5. Elimination of wastes and increasing the profitability.
FUNDAMENTAL CONCEPTS OF BUDGETING

Budgeting and Human Behavior

• Participative Budgeting: Each level of

management should be invited to
participate
• May inspire higher levels of performance
or discourage additional effort
• Depends on how budget developed and
administered

LO 15
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FUNDAMENTAL CONCEPTS OF BUDGETING

Budgeting and Human Behavior

 Advantages of Participative Budgeting

 More accurate budget estimates because lower level managers
have more detailed knowledge
 Perceive process as fair due to involvement of lower level
management
 Overall goal - produce fair and achievable budget while still
meeting corporate goals

 Disadvantages of participative Budgeting

 Can be time consuming and costly
 Can foster budgetary “gaming” through budgetary slack
Flow of budget data under participative budgeting

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TYPES of BUDGETARY SYSTEMs
Types of Budgetary Systems
• A business creates a budget when it wants to
match its actual future performance to an ideal
scenario that incorporates its best estimates of
sales, expenses, asset replacements, cash flows,
and other factors.
• There are a number of alternative budgeting
models available. The following list
summarizes the key aspects and disadvantages
of each type of budgeting model.
 Types of Budgets
• Static (or Fixed) Budgeting
• This is the classic form of budgeting, where a business
creates a model of its expected results and financial
position for the next year, and then attempts to force
actual results during that period to align with the budget
model as closely as possible.
• This budget format is typically based on a single expected
outcome, which can be extremely difficult to achieve.
• It also tends to introduce a great deal of rigidity into an
organization, rather than allowing it to react quickly to
ongoing changes in its environment.
 Types of Budgets
• Zero-Base Budgeting
• A zero-base budget involves determining what outcomes
management wants, and developing a package of
expenditures that will support each outcome. By
combining the various outcome-expenditure packages, a
budget is derived that should result in a specific set of
outcomes for the entire business.
• This approach is most useful in service-level entities, such
as governments, where the provision of services is
paramount. However, it also takes a considerable amount
of time to develop, in comparison to the static budget.
 Types of Budgets

• Flexible Budgeting
• A flexible budget model allows you to enter different sales
levels in the model, which will then adjust planned
expense levels to match the sales levels that have been
entered.
• This approach is useful when sales levels are difficult to
estimate, and a significant proportion of expenses vary
with sales.
• This type of model is more difficult to prepare than a static
budget model, but tends to yield a budget that is
reasonably comparable to actual results.
 Types of Budgets
.
• Incremental Budgeting
• Incremental budgeting is an easy way to update a
budget model, since it assumes that what has
happened in the past can be rolled forward into the
future.
• Though this approach results in simplified budget
updates, it does not provoke a detailed examination of
company efficiencies and expenditures, and so does
not assist in the creation of a lean and efficient
enterprise.
Types of Budgets

• The Rolling Budget

• A rolling budget, also called continuous budget, requires
that a new budget period be added as soon as the most
recent period has been completed. By doing so, the
budget always extends a uniform distance into the future.
• However, it also requires a considerable amount of
budgeting work in every accounting period to formulate
the next incremental update. Thus, it is the least efficient
budgeting alternative, though it does focus ongoing
attention on the budget.
Types of Budgets

• The Periodic Budget

• A periodic budget is a budget that is prepared for a
specified period of time, usually one year. As each budget
period ends, the organization prepared a new budget for the
next one.
• Hence, it is a one-off budget set for a year (e.g.). It is
normally broken down into monthly or weekly amounts.
• Advocates of periodic budgeting argue that continuous
budgeting takes too much time and effort and that periodic
budgeting provides virtually the same benefits at a smaller
cost.
 The Master Budget
• Is the total budget package for an organization.

• It is the end product that consists of all the

individual budgets for each part of the organization
aggregated into one overall budget for the entire
organization.
•

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Components of the Master Budget
• Contains two classes of budgets:
o Operating budgets:
 Includes Sales budget , Purchases budget ,Cost of goods
sold budget and Operating expense budget
 Result in the preparation of budgeted income statement

o Financial budgets
• Capital expenditures budget, cash budget, and
budgeted balance sheets

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Preparing Budget

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 Illustration Example
Sales Budget
Production Budget

Direct Materials Purchase Budget .

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 1.Sales Budget
Factors considered in sales forecasting:
 General economic conditions
 Industry trends
 Market research studies
 Anticipated advertising and promotion
 Previous market share
 Price changes
 Technological developments

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 Sales Budget cont…
• Sales budget first budget to be prepared

• Derived from sales forecast

• Every other budget depends on sales budget

Sales budgets are influenced by a wide variety of factors:

 General economic conditions,
 Pricing decisions,
 Competitor actions,
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
Sales Budget Cont…
To develop accurate sales budget, firms employ many
experts to assist in sales forecasting.
A sales forecast is a prediction of sales under a given
conditions.
Prepared by multiplying expected unit sales volume for
each product times anticipated unit selling price

Budgeted Sales = Budgeted Sales in

Units X Budgeted Sales Prices

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Sales Budget
Illustration: Morka Textile Export Company
• Budgeted sales volume: 3,000 units in the first quarter
with 500-unit increases in each succeeding quarter for
2020 budget year ending December 31 and the first two
quarters of 2021 .
• Sales price: $60 per unit.
Required:
• Prepare sales budget for the 4 quarters and annual sales
of 2020.

LO 2 34
Sales Budget Cont…

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 2. Production Budget in units
• Shows units that must be produced to meet anticipated
sales
• Derived from sales budget, Beginning finished goods
inventory and the desired ending finished goods
inventory
• Essential to have a realistic estimate of ending inventory

Budgeted Desired Ending Beginning Required

Sales Units  Finished Goods  Finished  Production
Units Goods Units Units
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 Production Budget Cont…

•Morka Company always believes that it can meet future sales

needs with an ending inventory of 20% of next quarter’s
budgeted sales volume.
Thus,
Budgeted sales of each quarter in units
1 2 3 4 1 2
3,000 3,500 4,000 4,500 5,000 5,500
Desired Ending FG Inventory of each quarter in units
1 2 3 4
700 800 900 1,000
Ending balance of current quarter will be beginning balance for
the next quarter.(1st Q. beginning= 3000*.2=600) 37
 Production Budget Cont…
Therefore ,the production budget of 2020 will be as
follows:

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3. Direct Materials Purchase Budget

•Shows quantity and cost of direct materials to be purchased.

•Derived from:
• The direct materials units required for production
(from the production budget),
•Beginning direct materials units and
•The desired change in ending direct materials units

LO 2 39
Direct Materials Purchase Budget cont…
Direct Desired Beginning Direct Materials
Materials Units  Ending Direct  Direct  Required to Be
Required for Materials Materials Purchased
Production Units Units

Units to Be Direct Materials Direct Materials

Produced  Units per Unit of  Units Required for
Unit Produced Production

Direct Materials Cost per Direct Cost of Direct

Units to Be  Materials Units  Materials
Purchased Purchased
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 Direct Materials Purchase Budget Cont…

Illustration data
• Each unit produced requires two pounds of raw materials
at a cost of $4 per pound
• Morka Company maintains an ending inventory of raw
materials equal to 10% of the next quarter’s raw material
required for production
• The desired ending direct materials amount is 1,020
pounds for the fourth quarter of 2020
• Prepare a Direct Materials purchase Budget

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Direct Materials Purchase Budget Cont..

a
10% of next quarter’s production requirements
b
10% of estimated first-quarter pounds needed for production
c
Total pounds needed for production is assumed to be 10,200 for the first quarter
for 2021
 Illustration Example
Direct Labor Cost Budget
Manufacturing Overhead Cost Budget

Selling &Administrative Expense

Budget .

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 1. Direct Labor Budget
• Shows both quantity of hours and cost of direct labor
necessary to meet production requirements
• Critical in maintaining a labor force that can meet
expected production
• Total direct labor cost formula:

Units to Be Direct Labor Direct Labor Total Direct

Produced  Hours per  Cost per  Labor Cost
Unit Hour
 Direct Labor cost Budget cont…
Illustration data :

 Direct labor hours are determined from the production

budget.

At Morka Company, two hours of direct labor are required

to produce each unit of finished goods.

The anticipated hourly wage rate is $10.

Prepare direct labor cost budget

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Direct Labor Cost Budget cont…

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2. Manufacturing Overhead Budget
• Shows expected manufacturing overhead costs for
budget period
• Manufacturing overhead should be distinguished
between fixed and variable overhead costs for budgeting
purpose
• Typically, the variable portion of manufacturing
overhead is assumed to be proportional to budgeted
activity(production)
• The fixed portion manufacturing overhead is assumed
to be constant in total

LO 3 47
Illustration data
Morka Company expects variable costs to fluctuate with
production volume on the basis of the following rates per direct
labor hour:
• Indirect materials $1.00, indirect labor $1.40, utilities $0.40,
and maintenance $0.20.
The company's Fixed OH cost are constant across each
quarters as follows:
• Supervisory salary $20,000, depreciation $3,800 , property
$9,000 tax and insurance and maintenance(fixed element)
$5,700 per quarter
Prepare a Manufacturing Overhead Budget.
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Manufacturing Overhead Budget cont…
 3. Selling and Adm. Expense Budget
• Is anticipated operating expenses and distinguished
between fixed and variable costs
Illustration Data:

 Variable selling and administrative expense rates are :

 Sales commissions $3 per units sold and freight-out
$1 per units sold .
 Fixed selling and administrative expense are constant and
per quarter: Advertising $5,000 , sales salary $15,000,
office salary $7,500, depreciation $1,000 , property tax
and insurance $1,500
Prepare a selling and administrative expense budget. 50
Selling and Adm. Expense Budget
4. Budgeted Income Statement
• Important end-product of operating budgets
• Indicates expected profitability of operations
• Provides a basis for evaluating company performance
• Prepared from operating budgets like:
 Sales budget  Manufacturing Overhead
 Direct Materials budget budget
 Direct Labor budget  Selling and Administrative
Expense budget

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 Budgeted Income Statement
Computation of Cost of Goods Sold
Illustration: To find the cost of goods sold, the Company must
first determine the total unit cost of producing one unit of
finished goods,
= DMC per unit + DLC per unit + OHC per unit:
DMC per unit = 2 pounds/unit of FG X $4….. $8
DLC per unit = 2 hrs/unit of FG * $10….. $20
Predetermined rate = Budgeted OH Cost / Budgeted labor hr
= $246,400/30800hrs= $8/hr
1unit of FG Demands 2 labor hours, thus OHC per unit = 2
hrs/unit of FG * $8….. $16
Manufacturing cost per unit $44
 Budgeted Income Statement
Computation of Cost of Goods Sold cont…

Second, determine budgeted Cost of Goods Sold

= budgeted units to be sold X manufacturing cost per unit
= 15,000 units(annual sales) × $44 = $660,000.

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Budgeted Income Statement
Illustration
All data for the income statement come from the operating budgets
except the following: (1) interest expense is expected to be $100,
and (2) income taxes are estimated to be $12,000.
Cash Budget and Budgeted Balance Sheet

Prepare a cash budget and a budgeted balance sheet.

Cash Budget
• Shows anticipated cash flows
• Important output in preparing financial budgets
• Contains three sections:
o Cash Receipts
o Cash Disbursements
o Financing
• Shows beginning and ending cash balances

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 Cash Budget
Cash balance, beginning xxx
Add : Collection from customers xxx
Total available cash before financing XXX

Total disbursements xx
Minimum cash balance xx
Total cash need xxxx
Excess (deficiency) of cash xxx
Financing( borrowing, repayment ) XX(XX)
Cash balance, Ending xxxx
Cash Budget
Cash Receipts Section

o Expected receipts from the principal sources of

revenue
o Expected interest and dividends receipts,
o proceeds from planned sales of investments, plant
assets, and the company’s capital stock
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Cash Budget
Cash Disbursements and Financing Sections

• Cash Disbursements Section

o Expected cash payments for direct materials, direct
labor, manufacturing overhead, and selling and
administrative expenses
• Financing Section
o Expected borrowings and repayments of borrowed
funds plus interest

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Cash Budget
Concepts
• Must prepare in sequence
• Ending cash balance of one period is beginning cash balance for
next
• Data obtained from other budgets and from management
• Often prepared for the year on a monthly basis
• Contributes to more effective cash management
• Shows managers the need for additional financing before actual
need arises
• Indicates when excess cash will be available

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Cash Budget
1. Schedule of Expected Collections
•To prepare the cash budget, it is useful to prepare a schedule
for collections from customers.
•This schedule is based on the following assumption.
•From Sales budget of each quarter, 60% are cash sales and
40% are credit sales to be collected in the following quarter.
•Accounts receivable of $60,000 at December 31, 2019, are
expected to be collected in full in the first quarter of 2020.

LO 4 61
Cash Budget
Illustration of Schedule of Expected Collections
Prepare a schedule of collections from customers.

a
Per Illustration 9.3; b$180,000 × .60; c$180,000 × .40 62
Cash Budget- Cash Payment

2. Schedule of Expected Payments for DM purchase

•From Direct materials purchase budget, 50% are
purchase on cash and 50% are on credit and paid in the
following quarter.
•Accounts payable of $10,600 at December 31, 2019, are
expected to be paid in full in the first quarter of 2020.

LO 4 63
Cash Budget - Cash Payment
Illus. of Schedule of Expected Payments for DM
Prepare a schedule of expected cash payments for direct materials.

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a
Per Illustration 9.9; $25,200 × .50; $25,200 × .50
b c
Cash Budget - Cash Payment
Additional payments data
The preparation of Morka’s Company’s cash budget is based on the
following additional assumptions.
3. January 1, 2020, cash balance is expected to be $38,000. Morka
wishes to maintain a balance of at least $15,000.
4. Short-term investment securities are expected to be sold for
$2,000 cash in the first quarter.
5. Direct labor cost is 100% is paid in the quarter incurred.
6. Manufacturing overhead , selling and administrative expenses ,
All items except depreciation are paid in the quarter incurred.

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Cash Budget - Cash Payment
Additional payments data

7. Management plans to purchase a truck in the second quarter for

$10,000 cash.
8. Morka makes equal quarterly payments of its estimated $12,000
annual income taxes.
9. Loans at 13.33% where there is a need to borrow and repaid in
earliest quarter when there is sufficient cash ($15,000 minimum
required balance).

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Complete Cash Budget Illustration
Budgeted Balance Sheet
• Projection of financial position at end of budget period
• Developed from budgeted balance sheet for preceding
year and budgets for current year.
Illustration: Pertinent data from the budgeted balance sheet at
December 31, 2019, are as follows.
Buildings and equipment $182,000
Common stock 225,000
Accumulated depreciation 28,800
Retained earnings 46,480

LO 4 68
Budgeted Balance Sheet
Problem data for assets
Cash: Ending cash balance $37,900, shown in the cash budget
(Illustration 9.19).
Accounts receivable: 40% of fourth-quarter sales $270,000,
shown in the schedule of expected collections from customers
(Illustration 9.17).
Finished goods inventory: Desired ending inventory 1,000
units, shown in the production budget (Illustration 9.5) times
the total unit cost $44 (shown in Illustration 9.14).

LO 4 69
Budgeted Balance Sheet
More problem data for assets
Raw materials inventory: Desired ending inventory 1,020 pounds,
times the cost per pound $4, shown in the direct materials budget
(Illustration 9.9).
Buildings and equipment: December 31, 2019, balance $182,000,
plus purchase of truck for $10,000 (Illustration 9.19).
Accumulated depreciation: December 31, 2019, balance $28,800,
plus $15,200 depreciation shown in manufacturing overhead budget
(Illustration 9.12) and $4,000 depreciation shown in selling and
administrative expense budget (Illustration 9.13).

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Budgeted Balance Sheet
Problem data for liabilities and equity
Accounts payable: 50% of fourth-quarter purchases $37,200,
shown in schedule of expected payments for direct materials
(Illustration 9.18).
Common stock: Unchanged from the beginning of the year.
Retained earnings: December 31, 2019, balance $46,480,
plus net income $47,900, shown in budgeted income statement
(Illustration 9.15).

LO 4 Copyright ©2018 John Wiley & Sons, Inc. 71

Complete Budgeted Balance Sheet Illus.

72
End

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Exercises

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 Sales, Production, and DM Budgets
Exercise

Assume the following data for Soliyana Company 2020.

Relevant data pertaining to its sales, production, and direct
materials budgets are as follows.
1. Sales. Sales for the year are expected to total 1,200,000
units. Quarterly sales, as a percentage of total sales, are
20%, 25%, 30%, and 25%, respectively. The sales price is
expected to be $50 per unit for the first three quarters and
$55 per unit beginning in the fourth quarter. Sales in the
first quarter of 2021 are expected to be 10% higher than
the budgeted sales for the fourth quarter of 2020.

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Production and Direct materials data

2) Production. Management desires to maintain the

ending finished goods inventories at 25% of the next
quarter’s budgeted sales volume.
3) Direct materials. Each unit requires 3 units of raw
materials at a cost of $5 per unit. Management desires
to maintain raw materials inventories at 5% of the next
quarter’s production requirements. Assume the
production requirements for the first quarter of 2021
are 810,000 units.
Required : Prepare sales, production and DM purchase
budget
LO 2 76
Budgeted Income Statement
Exercise
Soliyana Company is preparing its budgeted income
statement for 2020. Relevant data pertaining to its sales,
production, and direct materials budgets can be found on the
following slide. Soliyana budgets 0.5 hours of direct labor per
unit, labor costs at $15 per hour, and manufacturing overhead
at $25 per direct labor hour. Its budgeted selling and
administrative expenses for 2020 are $12,000,000.
a. Calculate the budgeted total unit cost.
b. Prepare the budgeted income statement for 2020.

LO 3 77
Solutions

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Solution : Production Budget
Prepare production budgets by quarters for 2020.

25% of next quarter's unit sales

a

b
Estimated first-quarter 2021 sales units: 240,000 + (240,000 × .10) = 264,000: 264,000 × .25
25% of estimated first-quarter 2020 sales units (240,000 × .25)
c

LO 2 80
Solution : Direct Materials Budget

a
Estimated first-quarter 2021 production requirements: 810,000 × .05 = 40,500
b
5% of estimated first-quarter pounds needed for production

LO 2 81
Solution : Budgeted Income Statement

Calculation of budgeted total unit cost

Cost Element Quantity Unit Cost Total
Direct materials 3.0 pounds $ 5 $ 15.00
Direct labor .5 hours 15 7.50
Manufacturing overhead .5 hours 25 12.50
Total unit cost $ 35.00

LO 3 82
Solution:Budgeted income statement for 2020

LO 3 83
End

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