CHAPTER THREE

3. Information for budgeting, planning and control purposes

Introduction
In “A Dictionary for Accountants”, Kohler defines budget as:
1. Any financial plan serving as an estimate of and a control over future operations.
2. Hence, any estimate of future costs.
3. Any systematic plan for the utilization of manpower, material or other resources.
The CIMA defines a budget as “A plan expressed in money. It is prepared and approved prior to
the budget period and may show income, expenditure and the capital to be employed. May be
drawn up showing incremental effects on former budgeted or actual figures, or be compiled by
zero-based budgeting.”
A budget is a precise statement of the financial and quantitative implications of the course of
action that management has decided to follow in the immediate next period of time (usually a
year).
Thus the essential features of a budget are as follows:
(i) It is a statement expressed in monetary and/or physical units prepared for the implementation
of policy formulated by the management.
(ii) It is laid down prior to the budget period during which it is followed.
(iii) It is prepared for the definite future period.
(iv) The policy to be followed to attain the given objective must be laid before the budget is
prepared.
Budgeting
Budgeting is the complete process of designing, implementing and operating budgets. The main
emphasis in this is short-term budgeting process involving the provision of resources to support
plans which are being implemented.
Budgetary Control
It’s intimately connected with budgets. The CIMA defines budgetary control as “the
establishment of budgets, relating the responsibilities of executive to the requirements of a policy
and the continuous comparison of actual with budgeted results either to secure by individual
action the objectives of that policy or to provide a firm basis for its revision”. A budgetary
control system secures control over performance and costs in the different parts of a business:
(i) by establishing budgets
(ii) by comparing actual attainments against the budgets; and
(iii) by taking corrective action and remedial measures or revision of the budgets, if necessary.
The budget is a blue-print of the projected plan of action expressed in quantitative terms and for
a specified period of time. The budgets put the plan in a concrete form and follow up action to
see that plan is adhere to complete the system of control. In other words, while budgeting is the
art of planning, budgetary control is the act of adhering to the plan. In fact, budgetary control
involves continuous comparison of actual results with the budgets and taking appropriate
remedial action promptly.

1
It is well recognized that a control system involves fixing of targets (in the form of specific
tasks), collection of information regarding actuals and continuous comparison of actuals with the
targets with a view to reporting for action. A budgetary control system, in this sense is also a
control system. It is an excellent system for decentralization of authority without losing control
over the operations of the firm. One should not consider (budgets or) budgetary control as
something rigid or strait-jacket. It is one of the system whereby dynamism is infused into an
organization through the process of targets, the achievement of which will mean progress; of
allowing a good deal of freedom of action within the delegated field of executives and of seeing
to it that all concerned will work in a concerted manner for achieving the firm’s objectives.
3.1 Objectives and concepts of budgetary systems
Budgeting and behavioral influences,
1) Dysfunctional Behavior: Budgets can bring positive behavior among the people when the
goals of individual managers are found in conformity with the goals of the organization. The
perfect matching (or near perfect matching) between the organizational and managerial goals is
often referred to as goal congruence. The managers who participate in the budget making process
may feel happy in producing a fair budget in terms of organizational goals and objectives.
(2) Participative Budgeting: Budgeting processes are either top down or bottom up. In a top-
down budgeting process, top management prepares budgets for the entire organization, including
those for lower-level operations. This process often is referred to as authoritative budgeting. A
participative budgeting process, on the other hand, is a bottom-up approach that involves the
people affected by the budget, including lower-level employees, in the budget preparation
process. Participation by employees in the budget preparation can provide them the feeling that
“this is our budget,” rather than the feeling generally noticed among employees that “this is the
budget imposed by the top on us.”
(3) Excessive Pressure Created by Budgets: Budgets are used in to direct control and
coordinate all activities in the organization. In this task, budgets should not generate excessive
pressure and stress on the subordinate managers, supervisors and the people working in the
organization. In order to eliminate undesirable pressure, the budget goals and standards should
be set which are neither too high (tight) nor too low (loose). If the standards and the budgeted
goals are too high, motivation becomes poor and failing to achieve them may frustrate the
managers and in turn, this frustration can result into poorer performance.
(4) Budgetary Slack (Cushion): Budgetary slack, also known as padding the budget, takes
place when a manager deliberately underestimates revenues, overestimates costs and requests
more funds than needed to support the budgeted level of activities. The difference between the
revenue or cost projections that a person provides and a realistic estimate of the revenue or cost
is called budgetary slack.
(5) Top Management Support: The attainment of budget goals and standards at the lower and
middle level management depends to a large extent on the support, participation and cooperation
extended by top management in the preparation and execution of budgets. Top managers by their
actions should create an environment and give impression to the subordinate managers about

2
their commitment and support to the budget goals and objectives. Otherwise, the planning and
control function will be damaged in case subordinate managers think that their top managers are
not sincere while preparing and using the budgets.
(6) Inter-Departmental Conflict: The budgeting process is rightly considered a technical and
formal one. However, in reality, the budgeting process becomes most often an informal
bargaining process or wherein managers of different departments compete for organization
scarce resources. According to Hopwood this can lead to a dilution of original goals, as
managers try (and fight) for power and recognition. Departmental conflict or conflicts between
the managers are also due to the fact that different departments are found blaming each other
when they fail to achieve their targets.
Quantitative aids in budgeting
A learning curve is a mathematical concept that graphically depicts how a process is improved
over time due to learning and increased proficiency. The learning curve theory is that tasks will
require less time and resources the more they are performed because of proficiencies gained as
the process is learned. The learning curve was first described by psychologist Hermann
Ebbinghaus in 1885 and is used as a way to measure production efficiency and to forecast costs.
A learning curve is typically described with a percentage that identifies the rate of improvement.
In the visual representation of a learning curve, a steeper slope indicates initial learning that
translates into higher cost savings, and subsequent learning’s result in increasingly slower, more
difficult cost savings. The learning curve also is referred to as the experience curve, the cost
curve, the efficiency curve, or the productivity curve. This is because the learning curve provides
cost-benefit measurements and insight into all the above aspects of a company.
The idea behind this is that any employee, regardless of position, takes time to learn how to carry
out a specific task or duty. The amount of time needed to produce the associated output is high.
Then, as the task is repeated, the employee learns how to complete it quickly, and that reduces
the amount of time needed for a unit of output.
Activity-based budgeting
Activity-based budgeting is a budgeting system in which you record and analyze every activity
that creates a cost to find areas for improving efficiencies. After analyzing costs, you can create a
budget based on your findings. Activity-based budgeting is more comprehensive than traditional
budgeting since it involves additional calculations. This budgeting type aims to reduce costs and
improve efficiency, not just track expenses or adjust information based on inflation or other
related occurrences.
Benefits of activity-based budgeting There are several benefits of using activity-based
budgeting, including:
Better insights into operational costs: The main objective of activity-based budgeting is to cut
down on costs. It's an in-depth analysis of expenses and how they may affect a company's
performance. This gives better insight into both specific and overall operational expenses.
Added competitive edge: This type of budgeting helps you reduce production costs, increase
production efficiency and determine how to make products more cost-friendly. Using the budget

3
to evaluate activities may help management identify a change that can lower costs, such as a
revised facility lease or reduced shipping rate. After making changes, businesses may be able to
produce products at a lower cost than their competitors. This competitive edge might give them a
new market advantage.

Better budget management: An activity-based budget integrates operations management and

accounting in the budget process. Information about activities is necessary for calculations, and
it's important to factor in a wider variety of staff and their expertise when drafting the budget.
Operations management can clarify the basis of certain costs and better understand processes,
including inefficiencies. Accounting can use their knowledge to make the proper calculations
and provide results. All contributing parties to any costs can review the budget and see how they
may lower costs.

Improved budget control: Activity-based budgeting helps businesses make budgetary decisions
based on specific cost drivers, their amounts and their importance to company activities. Cost
drivers are any activities that trigger the cost of something else. It may be easier for a company
to gain specific and actionable budget control with activity-based budgeting. A company can
decide which activity to modify, determine a change and evaluate how that change affects the
budget.

Waste elimination: Activity-based budgeting helps cut costs and improve efficiencies. Activity-
based evaluations also rank the importance of activities. The process may identify some activities
that are obsolete, redundant or unnecessary. As you eliminate or reduce these activities,
production may become more efficient and save companies money in the long term.

Improved collaboration: Many cost drivers often involve multi-departmental operations. This
budgeting system can involve several departments, promoting cooperation across the
organization. To effectively eliminate unnecessary costs, departments can collaborate to see how
they may work together to create these efficiencies.

Control theory and budgeting

Budgetary Control
It’s intimately connected with budgets. The CIMA defines budgetary control as “the
establishment of budgets, relating the responsibilities of executive to the requirements of a policy
and the continuous comparison of actual with budgeted results either to secure by individual
action the objectives of that policy or to provide a firm basis for its revision”. A budgetary
control system secures control over performance and costs in the different parts of a business:
(i) by establishing budgets
(ii) by comparing actual attainments against the budgets; and
(iii) by taking corrective action and remedial measures or revision of the budgets, if necessary.
The budget is a blue-print of the projected plan of action expressed in quantitative terms and for
a specified period of time. The budgets put the plan in a concrete form and follow up action to

4
see that plan is adhere to complete the system of control. In other words, while budgeting is the
art of planning, budgetary control is the act of adhering to the plan. In fact, budgetary control
involves continuous comparison of actual results with the budgets and taking appropriate
remedial action promptly.
It is well recognized that a control system involves fixing of targets (in the form of specific
tasks), collection of information regarding actuals and continuous comparison of actuals with the
targets with a view to reporting for action. A budgetary control system, in this sense is also a
control system. It is an excellent system for decentralization of authority without losing control
over the operations of the firm. One should not consider (budgets or) budgetary control as
something rigid or strait-jacket. It is one of the system whereby dynamism is infused into an
organization through the process of targets, the achievement of which will mean progress; of
allowing a good deal of freedom of action within the delegated field of executives and of seeing
to it that all concerned will work in a concerted manner for achieving the firm’s objectives.
Uncertainty and budgeting
The budgets are prepared for the future period. Despite best estimates made for the future, the
predictions may not always come true. The future is always uncertain and the situation which is
presumed to prevail in future may change. The change in future conditions upsets the budgets
which have to be prepared on the basis of certain assumptions. The future uncertainties reduce
the utility of a budgetary control system.
Strengths and weaknesses of budgeting and budgetary control
Budgetary control makes all the differences between drifting in an unchartered sea and following
a well plotted course towards a predetermined distinction. It serves as a valuable aid to
management through planning, co-ordination and control.
The principal advantages of a budgetary control system are enumerated below:
(1) Budgetary control aims at maximization of profits through effective planning and control of
income and expenditure - directing capital and resources to the best and most profitable channel.
(2) There is a planned approach to expenditure and financing of the business so that economy is
affected in the utilization of funds to the optimum benefit of the concern.
(3) It provides a clear definition of the objective and policies of the concern and a tool for
objecting these policies to periodic examination.
(4) The task of managerial co-ordination is facilitated through budgetary control.
(5) Since each level of management is aware of the task and is fully conscious as to the best way
by which it is to be performed, maximum effective utilization of men, materials and resources
can be attained.
(6) Reports are furnished under the principles of management or control by exception. Only
deviations from budgets which point out the weak spots and inefficiencies are properly looked
into.
(7) It cultivates in the management the habit of thinking ahead - making careful study of the
problems in advance before taking decisions.

5
(8) A budgetary control system assists delegation of authority and is a powerful tool of
responsibility accounting.
(9) Budgets are the fore-runners of standard costs in the sense that they create necessary
conditions to suit setting up of standard costs.
(10) The method of evaluating performance against budgets provides a suitable basis for
establishing incentive system of remuneration by results as also spotting people with exceptional
qualities of leadership and management.
(11) Since it involves foreseeing difficulties of various types, it will lead to their removal in time.
Limitations of budgetary control
(1) Budgetary control starts with the formulation of budgets which are mere estimates.
Therefore, the adequacy or otherwise of budgetary control system, to a very large extent,
depends upon the adequacy or accuracy with which estimates are made.
(2) Budgets are meant to deal with business conditions which are constantly changing.
Therefore, budgets estimates lose much of their usefulness under changing conditions because of
their rigidity. It is necessary that budgetary control system should be kept adequately flexible.
(3) The system of budgetary control is based on quantitative data and represent only an
impersonal appraisal to the conduct of business activity unless it is supported by proper
management of personal administration.
(4) It has often been found that in practice the organization of budgetary control system become
top heavy and, therefore, costly especially from the point of view of small concern.
(5) Budgets and budgetary control have given rise to a very unhealthy tendency to be regarded as
the solvent of all business problems. This has resulted in a very Luke-warm human effort to deal
with such problems and ultimately results in failure of budgetary control system.
(6) It is a part of human nature that all controls are resented to. Budgetary control which places
restrictions on the authority of executive is also resented by the employees.
3.2 Types of budgetary systems
Fixed budgets and flexible budgets
A budget may be established either as a fixed budget or a flexible budget. A fixed budget is a
budget designed to remain unchanged irrespective of the level of activity actually attained. A
fixed budget is one which is designed for a specific planned output level and is not adjusted to
the level of activity attained at the time of comparison between the budgeted and actual costs.
Obviously, fixed budgets can be established only for a small period of time when the actual
output is not anticipated to differ much from the budgeted output. However, a fixed budget is
liable to revision if due to business conditions undergoing a basic change or due to other reasons,
actual operations differ widely from those planned in the fixed budget. These budgets are most
suited for fixed expenses but they have only a limited application and is ineffective as a tool for
cost control.
Flexible budgets
The Chartered Institute of Management Accountants, London defines flexible budget as a budget
which by recognizing different cost behavior patterns, is designed to change as volume of output

6
changes. It is a budget prepared in a manner so as to give the budgeted cost for any level of
activity. It is a budget which by recognizing the difference between fixed, semi-fixed and
variable cost is designed to change in relation to the activity attained. It is designed to furnish
budgeted cost at any level of activity attained.
Flexible budgeting is desirable in the following cases:
(i) Where the level of activity during the year varies from period to period, either due to the
seasonal nature of the industry or to variation in demand.
(ii) Where the business is a new one and is difficult to foresee the demand.
(iii) Where the undertaking is suffering from shortage of a factor of production such as materials,
labor, plant capacity, etc.
The main characteristic of flexible budget is that it shows the expenditure appropriate to various
levels of output. If the volume changes the expenditure appropriate to it can be established from
the flexible budget for comparison with actual expenditure as a means of control. It provides a
logical comparison of budget allowances with actual cost. When flexible budget is prepared,
actual cost at actual activity is compared with budgeted cost at actual activity i.e. two things to a
like base. For preparation of flexible budget, items of cost have to be analyzed individually to
determine how different items of cost behave to change in volume. Therefore, in-depth cost
analysis and cost identification is required for preparation of flexible budget.
Following are the striking features of flexible budgets:
(i) They are prepared for a range of activity instead of a single level
(ii) They provide a very dynamic basis for comparison because they are automatically geared to
changes in volume.
(iii) They provide a tailor-made budget for a particular volume.
(iv) These are based upon adequate knowledge of cost behavior pattern.
Flexible budgets may be prepared in the following method:
(i) Tabular method or multi-activity method
(ii) Formula method or ratio method and
(iii) Graphic method.
Zero base budgeting and incremental budgeting
Zero base budgeting is a revolutionary concept of planning the future activities and there is a
sharp contradiction from conventional budgeting. Zero base budgeting, may be better termed as
“De nova budgeting” or budgeting from the beginning without any reference to any base-past
budgets and actual happening. Zero base budgeting may be defined as “a planning and budgeting
process which requires each manager to justify his entire budget request in detail from scratch
(hence zero base) and shifts the burden of proof to each manager to justify why he should spend
any money at all. The approach requires that all activities be analyzed in decision packages
which are evaluated by systematic analysis and ranked in order of importance”.
CIMA defines zero base budgeting as “a method of budgeting whereby all activities are re-
evaluated each time a budget is set. Discrete levels of each activity are valued and a
combination chosen to match funds available.”

7
It is a technique which complements and links the existing planning, budgeting and review
processes. It identifies alternative and efficient methods of utilizing limited resources in effective
attainment of selected benefits. It is a flexible management approach which provides a credible
rationale for reallocating resources by focusing on systematic review and justification of the
funding and performance levels of current programs of activities.
The concept of zero base budgeting was developed in U.S.A. Under zero-base budgeting, each
program and each of its constituent part is challenged for its very inclusion in each year’s budget.
Program objectives are also re-examined with a view to start things afresh. It requires review
analysis and evaluation of each program in order to justify its inclusion or exclusion from final
budget. Following steps are usually involved:
(i) Describing and analyzing all current or proposed programs usually called “decision
packages”. This consists of identification, analysis and formulation assists an evaluation in terms
of purposes, consequence, performance measures, alternatives and cause and benefits. Decision
units are the lowest level programs or organizational entity for which budgets are prepared.
(ii) Ranking of decision packages along with documents in support of these packages.
(iii) The sources are allocated in accordance with the ranking.
Zero-base budgeting is based on the premise that every rupee of expenditure requires
justification. The traditional budgeting approach includes expenditures of previous year which
are automatically incorporated in new budget proposals and only increments are subjected to
debate. Zero base budgeting assumes that a responsibility center manager has had no previous
expenditure. Important features of zero-base budgeting are:
(i) Concentration of efforts is not simply on “how much” a unit will spend but “why” it needs to
spend.
(ii) Choices are made on the basis of what each unit can offer for a specific cost.
(iii) Individual unit’s objects are linked to corporate targets.
(iv) Quick budget adjustments can be made if; during the operating year costs are required to
maintain expenditure level.
(v) Alternative ways are considered.
(vi) Participation of all levels in decision-making.
Incremental budgeting is a type of a budgeting process that is based on the idea that a new
budget can best be developed by making only some marginal changes to the current budget. In
other words, with incremental budgeting, the current budget is used as a base to which
incremental assumptions are added or subtracted from the base amounts to determine new budget
amounts. Among all budgeting methods, incremental budgeting is commonly considered as the
most conservative approach.
Periodic and Continuous budgeting,
A periodic budget, as the name suggests, involves dividing the annual budget into smaller
periods. It is more useful to refer to pay periods since money coming in and out centers around
them. To establish a periodic budget, you have to know the available amount of your cash assets
when creating the budget. An up-to-date cheque book allows you instant access to this

8
information. Income has to be entered in the periods it is deposited. You have to be as precise as
possible when entering the amounts. Expenses also have to be entered in the exact times they
occur.
Continuous budgeting is the process of continually adding one more month to the end of a
multi-period budget as each month goes by. The continuous budgeting concept is usually applied
to a twelve-month budget, so there is always a full-year budget in place.
Short-term vs. long-term budgets
Short‐term Budget: In this budget forecasts and plans are given in respect of its operations for a
period of about one to five years. They are generally prepared in monetary units and are more
specific than long‐term budgets.
Long‐term Budget: These budgets are prepared on the basis of long‐term projection and portray
a long‐range planning. These budgets generally cover plans for three to ten years. In this regard it
is mostly prepared in terms of physical quantities rather than in monetary values.
3.3 Monitoring and controlling performance; the calculation of variances; the determination of
the causes of variances- Reading
3.4 Master budgets: Manufacturing Businesses
A master budget is an organization’s operating and financing plan for the upcoming period; it
translates short-term objectives into action steps.
Parts of Master Budgets
The master budget is also a comprehensive financial summary of the organization’s budgets. It
comprises both operating budgets and financial budgets.
Operating budgets are plans that identify resources needed to implement strategic projects and
to carry out budgeted activities such as sales and customer services, production, purchasing,
marketing, and research and development, and the acquisition of these resources. For a
manufacturer, operating budgets include production, purchasing, personnel, and marketing
budgets. The set of operating budgets culminates in a budgeted income statement.
Financial budgets identify sources and uses of funds for the budgeted operations, including
strategic projects and initiatives. Financial budgets include the cash budget, budgeted statement
of cash flows, the budgeted balance sheet, and the capital expenditures (including strategic
expenditures) budget.
Developing the master budget
A master budget is a comprehensive budget for a specific period. It consists of a capital budget
and a set of interrelated operating and financial budgets. As noted earlier, the capital budget
includes budgets to support strategic initiatives, programs, and projects.
The master budget is an integrative set of financial planning documents that incorporates a
number of individual budgets. It serves as a guide of what a company wants to achieve and what
it must accomplish to get there. It also allows the company to realistically project future cash
flows and financial position so that operations can be adjusted during the period if the company
gets off track. A key disadvantage is the extensive amount of time involved to create the master

9
budget. While the master budget is usually prepared on an annual basis, the focus in this material
will be primarily on budgets covering a single month or quarter for simplicity purposes.
The individual budgets consist of several operating and financial budgets. They are all
interconnected and must be prepared in a particular order because most budgets rely on
information generated within other budgets. The following exhibit shows the flow of information
from the individual budgets into the budgeted balance sheet---the final budget.

Production budget
Materials purchase budget
Direct labor budget Budgeted income statement Budgeted
Manufacturing
Sales budget overhead budget Budgeted cash flows statement Balance sheet
Selling and administrative budget
Capital acquisitions budget
Cash budget

While the order in which the budgets are listed are does not reflect the order in which they
should be prepared, you should find the order of preparation logical if you think about the format
of the income statement. Because the income statement begins with sales, the budgeting process
begins with the sales budget. Because cost of goods sold appears next on the income statement,
the manufacturing budgets, which flow into cost of goods sold, are prepared next. The selling
and administrative budget and the capital acquisitions budget are then prepared, which are
followed by the cash budget. The results of all these budgets flow into the budgeted income
statement, budgeted statement of cash flows, and finally, into the balance sheet. This material
presents the budgets in the order in which they should be prepared, with the first three operating
budgets---the sales budget, the production budget, and the materials purchases budget.
Sales Budget
The sales budget is prepared first because all other budgets rely on its information. The process
begins a forecast of revenues generated by the company's sales department and sales vice-
presidents. A number of sources are used by managers to estimate how much sales will occur in
the future, including economic forecasts, mathematical models, industry data, and statistical
trend analysis. For most companies, sales forecasting is the most difficult part of budgeting.
Fortunately for you, it is the easiest part, because this information will be provided as part of the
problem data. If it were up to each student to forecast sales, each student would generate a
different solution.
The general format of the sales budget consists of three line items. Companies that sell more than
one product will display a separate column for each product.
Walk Through Problem - Sales Budget
At January 1, 2018, Arrant, Inc. had 1,100 step stools on hand. Its policy is to maintain an ending
inventory equal to 15% of units needed for the next month’s sales. Arrant Co. estimates it will
sell 8,000 stools during the first month of 2018 with a 5% increase in sales each subsequent
month. Each stool is sold for $16. Prepare a sales budget for the March of 2018.

10
Solution
Because a sale is an independently generated amount that is not based on the number of units in
inventory, much of the inventory information provided in this problem is irrelevant for the sales
budget. You have been provided the sales in units for January. Sales during February will be 5%
larger than January:
February sales in units = 8,000 + 8000 * 5% = 8,400 units
Sales for March are expected to be another 5% more than February sales. The sales for March
are expected to be:
March sales in units = 8,400 x 105% = 8,820 units
Only amounts for future periods should be included in budgets. Prior period amounts are never
displayed because they are historical amounts, and by definition, a budget is an estimate of future
activity. Every budget should begin with a standard, three-line statement heading which includes
the company name, the name of the budget, and the time period it covers. The sales budget will
appear as follows:
Arrant. Inc.
Sales Budget
Month Ending March 31, 2018
Sales in units 8,820
Selling price per unit $ 16.00
Budgeted sales revenue $141,120
Production Budget
The production department manufactures products based on the number of units the sales
personnel forecast, which is reflected on the sales budget. It is prepared so that production
managers know how many units they will need to produce. This information enables the
production supervisor to hire and schedule employees and the purchasing department to plan for
ordering materials. The production budget is the only budget consisting of no monetary amounts.
It is important to make the distinction between two types of units in budgeting---finished goods
(FG) units and raw materials (RM) units. Raw materials are used to create finished goods. The
format of the production budget is:
Budgeted sales of finished goods units
+ Desired ending inventory of finished goods units
− Beginning inventory of finished goods units
= Finished goods units to be produced
Recall that the number of units produced rarely equals the number of units sold for most
companies. The ending balance of the current budget period is based on the number of units to be
sold during the next period. The beginning balance of the budget period is based on the number
of units to be sold during the current period, because as of the first day of the month, the next
budget period is the next 30 days of operations. Assume that the company estimates that 100
units will be sold in June, 120 in July, and 150 in August, and the company desires to have
ending inventory equal to 10% of the units to be sold during the next month. At the end of June,

11
the company wants to have 10% times July's expected sales: 10% x 120 = 12 units. At the end of
July, the company wants to have 10% times August's expected sales: 10% x 150 = 15 units.
Beginning inventory at the end of July is the same point in time as the end of June. As such,
because the company wants to have 12 units at the end of June, it will also desire 12 units at the
beginning of July. The following concept will always apply:
Ending inventory of one month is the same as the beginning inventory for the next month.
Walk Through Problem - Production Budget
Schroeder, Inc. sells placemats for $15 each. The company’s budgeted unit sales for 4 months
during 2018 appears below.
March 39,000
April 42,000
May 44,000
June 40,000
Schroeder desires to have total mats on hand at the end of each month equal to 15 percent of the
following month’s budgeted unit sales. Each mat requires 0.25 yards of fabric. At the end of each
month, Schroeder desires to have 20 percent of production material needs required for the next
month on hand. The fabric costs $2.60 per yard. Each mat produced requires 0.15 hours of direct
labor. Prepare a production budget for the month of April.
Solution
Step 1: Begin with the number of units the company expects to sell during April, a total of
42,000. This information is taken from the sales budget.
Step 2: Calculate the number of units the company desires to have on hand at the end of April.
The production department must produce enough units to cover the 42,000 to be sold, plus
additional units at month end, i.e., "15 percent of the following month’s budgeted unit sales."
These units will be used to begin the next month: 15% x 44,000 = 6,600 units at May 1. These
units are added to the number to be sold because they are extra units that must be produced.
Finished goods units to be sold 42,000
Step 3: Calculate the number of units the company desires to have on hand at the beginning of
April. The finished goods inventory balance at the end of March was budgeted at 15% times
April sales, giving 15% x 42,000 or 6,300 units estimated to be in inventory at March 31. The
last day of March (ending inventory of one month) and the first day of April (beginning
inventory of the next month) should always have the same inventory balance.
Step 4: Add the desired ending inventory and subtract the desired beginning inventory to
determine the number of finished goods units (i.e., placemats), the company will need to
produce.

12
 Schroeder, Inc.
Production Budget
Month Ending April 30, 2018
Finished goods units (placemats) to be sold 42,000
+ Desired finished goods in ending inventory 6,600
- Beginning finished goods inventory on hand expected (6,300)
Finished goods units (placemats) to be produced 42,300
Because the production budget determines the number of units to be produced, no dollar signs
are displayed.
Direct Materials Purchases Budget
The direct materials purchase budget depends on the units needed for production and the change
in the raw material inventories during the period. Begin with units to be produced, not sales
units. Why? Materials are purchased and used for production purposes, not to be sold.
The amount of direct materials to be purchased is calculated as follows:
Budgeted finished units to be produced
x Raw materials needed for each finished goods unit
= Total raw materials units needed for production
+ Desired raw materials ending inventory
− Beginning raw materials on hand
= Raw materials needed to purchase
x Cost per raw materials unit
= Budgeted cost of purchases
There are three cautions you should always remember for the direct materials purchases budget.
First, begin with units to be produced. Second, immediately convert and display all inventories in
the denomination in which the raw materials are purchased. Finally, always wait until the last
step to consider the cost of the materials.
Walk Through Problem - Direct Materials Purchases Budget
Trump Inc. produces trinkets. Each trinket requires 0.4 board feet of wood and 1.25 hours of
direct labor. Wood costs $1.40 per board foot. Trump pays it employees $18.00 per hour. Trump
desires to have 20% of the materials needed for production during the next month on hand at the
end of each month, and 15% of the number of trinkets to be sold the next month on hand at the
end of each month. Scheduled productions in units are:
April 4,100
May 4,700
June 5,300
Prepare a materials purchases budget for May in good form. Calculate budgeted raw materials
inventory on the balance sheet at May 31.

13
Solution
Step 1: Begin with the number of units to be produced. While both units to be sold and units to
be produced are often provided, you only need units 'produced' because those are the units in
which the materials will be consumed during the period.
Step 2: The second line of the budget converts the units to be produced (denominated in finished
goods units) to the denomination in which the materials are ordered....i.e., in board feet. Every
line item from this point forward in the materials purchases budget is denominated in board feet.
Multiply the board feet needed for each trinket by the number of trinkets the company plans to
produce:
Budgeted trinkets (FG) to be produced 4,700
Board feet needed for each trinket 0.4
Board feet needed for production 1,880
Step 3: Calculate and add in the desired ending inventory. This is often tricky because two
different 'ending inventories' are cited in the problem. Be sure you focus on 'raw materials' and
not 'finished goods.' We are concerned with the 20% inventory levels, not the 15% levels that
appear in this problem. This is because the 15% amount pertains to finished goods, and you
already know how many finished goods units to produce (i.e., the budgeted production numbers
are provided above.)
The raw materials requirements are: "desires to have 20% of the materials needed for production
during the next month on hand at the end of each month." Dates are important. The end of the
budget period is May 31. Because the 'next' month of production is the month of June, you can
conclude that the company desires to have enough materials on hand at May 31 to produce 20%
of June's budgeted finished units:
20% x 5,300 units x 0.4 board feet = 424 board feet
Budgeted trinkets (FG) to be produced 4,700
Board feet needed for each trinket 0.4
Board feet needed for production 1,880
Add desired raw materials ending inventory 424
Step 4: Calculate and subtract out the beginning inventory which is carried over from the
previous month (April). At the end of April, management desires to have 20% of the materials
needed for the next month---May. Production of 4,700 trinkets is expected to be produced in
May. Considering that each trinket uses 0.4 board feet of wood, the budgeted beginning
inventory is: 20% x 4,700 units x 0.4 board feet = 376 feet
The total board feet needed to purchase are determined by subtracting the beginning raw
materials inventory which results in a purchase requirement of 1,928 feet:
Budgeted trinkets (FG) to be produced 4,700
Board feet needed for each trinket 0.4
Board feet needed for production 1,880
Add desired raw materials ending inventory 424
Less beginning raw materials on hand (376)

14
 Board feet needed to purchase 1,928
Step 5: Once the number of feet to be purchased is determined, the cost per board foot is
factored in. The completed budget includes a standard three-line heading
Trump, Inc.
Materials Purchases Budget
Month Ending May 31, 2018
Budgeted trinkets (FG) to be produced 4,700
Board feet needed for each trinket 0.4
Board feet needed for production 1,880
Add desired raw materials ending inventory 424
Less beginning raw materials on hand -376
Board feet needed to purchase 1,928
Cost per board foot $1.40
Budgeted cost of purchases $2,699
Note that last line of the budget represents the 'cost' of purchases, not the cash to be paid for
purchases nor the cost of goods sold. Cash payments are often paid up to 30 days after purchases
are made and are calculated in the cash disbursements budget.
Step 6: To calculate budgeted raw materials inventory on the balance sheet at May 31, begin
with the number of feet that are budgeted to be on hand on May 31. This amount is labeled as
desired raw materials ending inventory in the materials purchases budget. This ending inventory
amount is multiplied by the cost per board foot to determine the ending raw materials inventory
cost.
Note that balance sheet amounts are always in dollars, not feet, pounds, yards, etc.
Board feet at May 31 = 20% x 5,300 x 0.4 = 424 board feet
Raw materials inventory cost at May 31 = 424 feet x $1.40 = $593.60.
• Merchandising Businesses- Reading

15