Budgeting and Budgetary Control (Copy)
Meaning and Purpose of Budgeting and Budgetary Control
- Budget: A financial and/or quantitative statement prepared in advance of a defined period of time, stating the policy to be pursued during that period for achieving a given objective.
- Budgetary control: The establishment of budgets relating to the responsibilities of executives and the continuous comparison of actual with budgeted results, either to secure by individual action the objectives of that policy or to provide a basis for its revision.
- Key purposes:
- Planning future activities.
- Coordinating different departments.
- Controlling resources by setting financial limits.
- Motivating staff by providing clear targets.
- Evaluating performance by comparing budgeted and actual outcomes.
- Communicating organisational goals.
Advantages of Budgetary Control System
- Provides clear direction and targets.
- Encourages forward planning by anticipating problems.
- Aids coordination across departments.
- Allows delegation of responsibility and accountability.
- Facilitates control through variance analysis.
- Helps in resource allocation to priority areas.
- Motivates managers if targets are realistic.
Disadvantages of Budgetary Control System
- May lead to rigidity if too strictly enforced.
- Can cause conflict if departments feel budgets are unfair.
- Preparation is time-consuming and costly.
- Unrealistic budgets can demotivate staff.
- Focus may be overly financial, ignoring non-financial aspects.
- Managers may manipulate figures to achieve targets.
- May encourage short-term thinking instead of long-term goals.
Advantages and Disadvantages of Using Spreadsheets in Budgeting
Advantages:
- Easy to edit, update and adjust figures.
- Provides automatic calculations, reducing errors.
- Allows scenario planning and flexible analysis.
- Easy to communicate electronically across departments.
- Visual presentation through charts and graphs.
Disadvantages:
- Risk of errors from incorrect formulas.
- Requires training for staff.
- Prone to data loss if not backed up.
- Can give a false sense of accuracy.
- Security concerns if access is not restricted.
Master Budget
- A comprehensive budget incorporating all functional budgets to give an overall plan for the organisation.
- Composed of:
- Budgeted statement of profit or loss.
- Budgeted statement of financial position.
- Supporting functional budgets (sales, production, cash, etc.).
Types of Budgets
- Sales Budget
- Prepared first.
- Forecasts expected sales volume and revenue.
- Example: If expected sales = 10,000 units at $20 each, sales budget = $200,000.
- Production Budget
- Based on sales forecast and inventory policy.
- Formula:
Production units = Sales units + Closing inventory – Opening inventory
- Purchases Budget
- Determines raw materials needed.
- Formula:
Purchases = (Materials required for production + Closing inventory of materials) – Opening inventory of materials
- Labour Budget
- Calculates labour hours and cost required.
- Formula:
Total labour hours = Units to be produced × Hours per unit
Labour cost = Total hours × Hourly rate
- Trade Receivables Budget
- Forecasts expected cash inflows from credit sales.
- Accounts for collection periods.
- Trade Payables Budget
- Forecasts expected cash outflows for credit purchases.
- Accounts for payment terms.
- Cash Budget
- Forecasts cash inflows and outflows.
- Identifies periods of surplus or deficit.
- Crucial for liquidity management.
- Budgeted Statement of Profit or Loss
- Forecasts revenues, costs and expected profit.
- Budgeted Statement of Financial Position
- Forecasts assets, liabilities and equity.
Limiting Factors (Key Factors)
- The factor which limits the activities of the business and restricts output.
- Examples:
- Shortage of skilled labour.
- Limited machine hours.
- Scarcity of raw materials.
- Limited sales demand.
- Budgets must be prepared considering the limiting factor.
Flexible Budgeting vs Fixed Budgeting
- Fixed budget: Prepared for one level of output; does not change with activity.
- Flexible budget: Adjusts costs and revenues for different levels of activity.
Advantages of Flexible Budgets:
- More realistic for performance evaluation.
- Useful when activity levels vary.
- Allows for meaningful variance analysis.
Preparation of a Flexible Budget Statement
- Step 1: Identify fixed, variable, and semi-variable costs.
- Step 2: Adjust costs based on actual level of activity.
- Example:
- Variable cost = $5 per unit, Fixed cost = $10,000
- At 2,000 units: Total cost = (2,000 × $5) + 10,000 = $20,000
Variance Analysis in Flexible Budgeting
- Possible causes of differences:
- Higher or lower sales demand.
- Unexpected cost increases.
- Inefficiency in labour or material usage.
- External factors such as inflation.
Reconciliation Statements
- Flexible Budgeted Cost vs Actual Cost
- Compares costs based on actual activity to actual costs incurred.
- Helps in identifying areas of inefficiency.
- Flexible Budgeted Profit vs Actual Profit
- Compares expected profit at actual activity level with actual profit achieved.
- Identifies reasons for under/over-performance.
Decision-Making and Recommendations Using Budget Data
- Budgets allow management to:
- Decide on cost control measures.
- Adjust selling prices.
- Plan financing if cash deficits are forecast.
- Evaluate departmental performance.
- Make investment and expansion decisions.
Behavioural Aspects of Budgeting
- Targets: Should be realistic and achievable to motivate staff.
- Incentives: Bonuses linked to budget achievement encourage performance.
- Motivation: Participation in budget setting increases employee commitment.
- Risks: Overly tough targets demotivate; easily achievable targets encourage slack.
Significance of Non-Financial Factors
- Customer satisfaction.
- Employee morale.
- Environmental sustainability.
- Innovation and research.
- Market reputation.
- These qualitative aspects must complement financial data for effective decisions.
4.3 Budgeting and Budgetary Control
4.3.1 Budgeting and Budgetary Control
Meaning and Purpose of Budgetary Control
- Budget: A financial or quantitative statement prepared in advance of a defined period, showing the policy to be pursued during that period.
- Budgetary control: A system of managing costs and revenues by comparing actual results with budgets and taking corrective action where necessary.
- Key purposes:
- Planning: Provides a roadmap for the organisation to allocate resources and achieve objectives.
- Coordination: Ensures all departments work in harmony toward common goals.
- Control: Highlights variances between actual and expected results, enabling management to intervene.
- Motivation: Acts as a target for staff, potentially encouraging efficiency and innovation.
- Performance evaluation: Allows managers’ effectiveness to be assessed against predetermined standards.
Advantages of Budgetary Control System
- Provides a framework for future planning and forecasting.
- Encourages coordination between departments.
- Ensures optimal allocation of scarce resources.
- Allows early identification of inefficiencies and wastage.
- Provides measurable benchmarks for performance evaluation.
- Enhances communication within the organisation.
- Facilitates decision-making, e.g. whether to expand, cut costs, or increase production.
Disadvantages of Budgetary Control System
- Preparation is time-consuming and costly.
- Requires accurate data, which may not always be available.
- Can create rigidity, reducing flexibility in responding to unexpected changes.
- May demotivate employees if targets are unrealistic.
- Managers may manipulate results (“budgetary slack”) to make targets easier.
- Can focus excessively on short-term goals rather than long-term strategy.
Budgets Using Spreadsheets
Advantages of spreadsheets in budgeting:
- Speed and efficiency in preparing multiple versions.
- Easy to modify assumptions and see immediate impact.
- Built-in formulae allow automation of calculations.
- Ability to prepare complex budgets (e.g. sensitivity analysis).
- Better presentation through charts and tables.
Disadvantages:
- Risk of human error in entering formulas.
- Over-reliance on software may reduce understanding of underlying figures.
- Security risks: spreadsheets may be easily altered or accessed without controls.
Master Budget
- Definition: A consolidated budget bringing together all functional budgets to form an overall financial plan for the organisation.
- Includes:
- Budgeted Statement of Profit or Loss.
- Budgeted Statement of Financial Position.
- Cash Budget.
- Acts as the ultimate control document against which actual performance is measured.
Preparation of Functional Budgets
- Sales Budget
- Forecast of expected sales revenue and volume.
- Basis for most other budgets.
- Factors: past sales, market trends, promotional activities, competitor actions.
- Production Budget
- Planned output required to meet sales demand.
- Formula:
Production = Sales + Closing inventory − Opening inventory
- Purchases Budget
- Quantity and cost of raw materials to be purchased.
- Formula:
Purchases = Materials required for production + Closing inventory − Opening inventory
- Labour Budget
- Number of labour hours required × Wage rate.
- Considers overtime, training, and potential staff shortages.
- Trade Receivables Budget
- Expected cash inflows from customers.
- Based on sales budget and credit terms (e.g. 60% in one month, 40% in two months).
- Trade Payables Budget
- Expected outflows to suppliers.
- Based on purchases budget and credit terms given by suppliers.
- Cash Budget
- Forecast of expected cash inflows and outflows.
- Identifies cash shortages or surpluses.
- Assists in planning short-term borrowing or investment of excess funds.
- Budgeted Statement of Profit or Loss
- Predicted revenues and costs.
- Shows expected profit.
- Budgeted Statement of Financial Position
- Shows forecasted assets, liabilities, and equity at the end of the budget period.
Limiting Factors in Budget Preparation
- Definition: The resource or condition that restricts the level of activity (e.g. machine capacity, labour hours, raw material supply, or sales demand).
- Budgets must be prepared considering the limiting factor.
- Priority should be given to products or activities with the highest contribution per unit of the limiting factor.
Flexible vs Fixed Budgets
- Fixed Budget: Prepared for a single level of output and does not change with actual activity.
- Limitation: becomes irrelevant if actual activity differs significantly.
- Flexible Budget: Adjusts costs and revenues based on actual levels of output.
- More realistic and useful for performance evaluation.
Flexible Budget Statement Preparation
- Identify fixed, variable, and semi-variable costs.
- Adjust variable and semi-variable costs according to actual activity levels.
- Compare with actual results to calculate variances.
Variance Analysis in Flexible Budgeting
- Causes of differences between actual and flexible budgeted data:
- Changes in prices of materials or labour.
- Efficiency or inefficiency of workforce.
- Machine breakdowns or production delays.
- Changes in market demand.
- Unforeseen economic or environmental events.
Statements of Reconciliation
- Reconciliation of Flexible Budgeted Cost of Production with Actual Cost of Production
- Highlights whether higher costs were due to inefficiency, higher prices, or volume changes.
- Reconciliation of Flexible Budgeted Profit with Actual Profit
- Explains differences in profitability caused by variances in sales, costs, and volumes.
Business Decisions and Recommendations Using Supporting Data
- Budgets provide evidence-based decision-making, e.g.:
- Should a company cut costs or increase production?
- Is additional finance required?
- Should new projects be pursued given budgeted cash flows?
- Budget data can be used to evaluate different strategic options.
Behavioural Aspects of Budgeting
- Targets: Realistic targets can motivate; unrealistic targets demotivate.
- Incentives: Linking bonuses to budget achievement can increase motivation but may encourage manipulation.
- Participation: Involving employees in budget setting can increase commitment (“ownership of budgets”).
- Conflict: Budgets may create tension between departments competing for resources.
Significance of Non-Financial Factors
- While budgets are financial, managers must also consider:
- Customer satisfaction and retention.
- Quality of goods and services.
- Employee morale and labour relations.
- Environmental sustainability.
- Compliance with regulations.
- Non-financial indicators may influence long-term success more than short-term financial results.
Worked Numerical Examples for 4.3 Budgeting and Budgetary Control
Example 1: Sales Budget
- Forecasted monthly sales of Product A:
- January: 1,200 units at $10 each
- February: 1,500 units at $10 each
- March: 1,800 units at $10 each
Sales Budget Calculation:
- January: 1,200 × 10 = $12,000
- February: 1,500 × 10 = $15,000
- March: 1,800 × 10 = $18,000
Total for Quarter = $45,000
Example 2: Production Budget
- Planned sales: 5,000 units
- Closing inventory: 1,000 units
- Opening inventory: 800 units
Formula:
Production = Sales + Closing inventory − Opening inventory
Calculation:
Production = 5,000 + 1,000 − 800 = 5,200 units
Example 3: Purchases Budget
- Material required per unit of output = 3 kg
- Production for the month = 5,200 units
- Closing inventory of raw materials = 2,000 kg
- Opening inventory of raw materials = 1,600 kg
- Cost per kg = $5
Formula:
Purchases = (Production × Material per unit) + Closing inventory − Opening inventory
Calculation:
Purchases = (5,200 × 3) + 2,000 − 1,600
Purchases = 15,600 + 2,000 − 1,600 = 16,000 kg
Cost = 16,000 × $5 = $80,000
Example 4: Labour Budget
- Labour hours required per unit = 2 hours
- Planned production = 5,200 units
- Wage rate = $12 per hour
Calculation:
Labour hours = 5,200 × 2 = 10,400 hours
Total Labour Cost = 10,400 × 12 = $124,800
Example 5: Trade Receivables Budget
- Sales (credit): $45,000 for Quarter 1
- Credit terms: 60% collected in same quarter, 40% next quarter
Calculation:
Cash inflow from Quarter 1 sales:
- Same quarter = 60% × 45,000 = $27,000
- Next quarter = 40% × 45,000 = $18,000
Total receipts in Quarter 1 = $27,000
Balance carried forward = $18,000
Example 6: Trade Payables Budget
- Purchases = $80,000
- Credit terms: pay 50% in same month, 50% next month
Calculation:
Payment in current month = 50% × 80,000 = $40,000
Payment in next month = $40,000
Example 7: Cash Budget
- Opening balance = $10,000
- Cash inflows: $27,000
- Cash outflows:
- Purchases paid = $40,000
- Labour = $124,800
Calculation:
Total outflows = 40,000 + 124,800 = 164,800
Net cash flow = 27,000 − 164,800 = −137,800
Closing balance = 10,000 − 137,800 = −127,800 (cash deficit)
Example 8: Flexible vs Fixed Budget
- Budget prepared for 5,000 units:
- Sales = $100,000
- Variable costs = $50,000
- Fixed costs = $30,000
- Profit = $20,000
- Actual production = 6,000 units
- Actual sales = $120,000
- Actual variable costs = $63,000
- Actual fixed costs = $32,000
Flexible Budget at 6,000 units:
- Sales = (100,000 ÷ 5,000) × 6,000 = $120,000
- Variable costs = (50,000 ÷ 5,000) × 6,000 = $60,000
- Fixed costs = $30,000
- Profit = 120,000 − 60,000 − 30,000 = $30,000
Actual Profit = $120,000 − 63,000 − 32,000 = $25,000
Variance: 30,000 (flexible) − 25,000 (actual) = $5,000 adverse
Example 9: Reconciliation of Flexible Budgeted Cost with Actual Cost
- Flexible budgeted cost (6,000 units): $90,000
- Actual cost: $95,000
Reconciliation:
- Variance = 95,000 − 90,000 = $5,000 adverse
Example 10: Reconciliation of Flexible Budgeted Profit with Actual Profit
- Flexible budgeted profit: $30,000
- Actual profit: $25,000
Difference = $5,000 adverse
- Reasons:
- Higher variable costs = $3,000
- Higher fixed costs = $2,000
Example 11: Limiting Factor Decision
- Contribution per unit:
- Product A: $20 contribution, requires 4 machine hours → Contribution per machine hour = 20 ÷ 4 = $5
- Product B: $15 contribution, requires 2 machine hours → Contribution per machine hour = 15 ÷ 2 = $7.50
- Limiting factor: 2,000 machine hours available
Decision:
- Prioritise Product B (higher contribution per machine hour).
- Allocate as many hours as possible to B before A.
Complete Worked Master Budget Example
Scenario:
- A company manufactures Product X.
- Sales forecast:
- January: 1,200 units at $10
- February: 1,500 units at $10
- March: 1,800 units at $10
- Policy:
- Closing inventory = 20% of next month’s sales
- Raw material per unit = 3 kg at $5/kg
- Labour = 2 hours per unit at $12/hour
- Fixed overheads = $30,000/month
- Credit sales: 60% collected in same month, 40% next month
- Purchases: 50% paid in same month, 50% next month
- Opening cash = $10,000
Step 1: Sales Budget
- January = 1,200 × 10 = $12,000
- February = 1,500 × 10 = $15,000
- March = 1,800 × 10 = $18,000
- Total Q1 = $45,000
Step 2: Production Budget
Formula: Production = Sales + Closing inventory − Opening inventory
- January:
Sales = 1,200
Closing inv. = 20% of Feb sales = 300
Opening inv. = 0 (first month)
Production = 1,200 + 300 − 0 = 1,500 units - February:
Sales = 1,500
Closing inv. = 20% of March sales = 360
Opening inv. = 300
Production = 1,500 + 360 − 300 = 1,560 units - March:
Sales = 1,800
Closing inv. = 20% of April sales (assume April forecast 2,000 → 400)
Opening inv. = 360
Production = 1,800 + 400 − 360 = 1,840 units
Step 3: Materials Purchases Budget
Formula: Purchases = (Production × Material per unit) + Closing inv. − Opening inv.
- Jan:
Required = 1,500 × 3 = 4,500 kg
Closing inv. = 20% of Feb’s requirement (1,560 × 3 × 20%) = 936
Opening inv. = 0
Purchases = 4,500 + 936 − 0 = 5,436 kg × $5 = $27,180 - Feb:
Required = 1,560 × 3 = 4,680 kg
Closing inv. = 20% of March req. (1,840 × 3 × 20%) = 1,104
Opening inv. = 936
Purchases = 4,680 + 1,104 − 936 = 4,848 kg × $5 = $24,240 - Mar:
Required = 1,840 × 3 = 5,520 kg
Closing inv. = 20% of April req. (2,000 × 3 × 20%) = 1,200
Opening inv. = 1,104
Purchases = 5,520 + 1,200 − 1,104 = 5,616 kg × $5 = $28,080
Step 4: Labour Budget
Formula: Labour = Production × Hours per unit × Wage rate
- Jan: 1,500 × 2 × 12 = $36,000
- Feb: 1,560 × 2 × 12 = $37,440
- Mar: 1,840 × 2 × 12 = $44,160
Step 5: Trade Receivables Budget
- Jan: 60% current = 12,000 × 60% = 7,200
40% next = 4,800 (to Feb) - Feb: 60% current = 9,000
40% next = 6,000 (to Mar) - Mar: 60% current = 10,800
40% next = 7,200 (to Apr)
Step 6: Trade Payables Budget
(Purchases split 50% current, 50% next)
- Jan purchases = 27,180 → 13,590 current, 13,590 next
- Feb purchases = 24,240 → 12,120 current, 12,120 next
- Mar purchases = 28,080 → 14,040 current, 14,040 next
Step 7: Cash Budget
Opening balance = $10,000
January:
- Inflows: 7,200
- Outflows: Purchases (13,590), Labour (36,000) = 49,590
- Net = −42,390
- Closing = 10,000 − 42,390 = −32,390
February:
- Inflows: 4,800 (from Jan) + 9,000 (Feb) = 13,800
- Outflows: Purchases (12,120 + 13,590 = 25,710), Labour (37,440) = 63,150
- Net = −49,350
- Closing = −32,390 − 49,350 = −81,740
March:
- Inflows: 6,000 (Feb) + 10,800 (Mar) = 16,800
- Outflows: Purchases (14,040 + 12,120 = 26,160), Labour (44,160) = 70,320
- Net = −53,520
- Closing = −81,740 − 53,520 = −135,260
Step 8: Budgeted Statement of Profit or Loss (Q1)
- Sales = 45,000
- Direct materials used = Jan (4,500×5) + Feb (4,680×5) + Mar (5,520×5) = 73,500
- Direct labour = 36,000 + 37,440 + 44,160 = 117,600
- Fixed overheads = 90,000 (30,000 × 3 months)
- Total costs = 281,100
- Gross loss = 45,000 − 281,100 = −236,100
(This shows a heavy loss → reason: sales price too low compared with high labour/material costs. Good teaching point!)
Step 9: Budgeted Statement of Financial Position (End March)
Assets:
- Cash = −135,260 (overdraft)
- Inventory:
- Finished goods (400 units × $41 each approx. = 16,400)
- Raw materials (1,200 kg × $5 = 6,000)
Total assets ≈ −112,860
Liabilities:
- Trade payables (14,040 from March still unpaid)
Net position: shows liquidity crisis
This Master Budget ties everything together: the sales plan → production plan → materials → labour → cash → profit → financial position.