Chapter 8

Chapter 8 –
Budgeting and Profit

Planning
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Learning Objectives
• Understand the planning process
• Explain the definition, meaning and purpose of a budget
• Discuss types of budgets and illustrate their preparation
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Introduction
• Budgets are an important tool of profit planning.
• There are different types of Budgets.
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Planning Process
• Planning involves specifications of basic objectives and fundamental policies.
• In operational terms, it involves four stages:
 Objectives
 Goals
 Strategies, and
 Plans/Budgets.
• Objectives are broad and long-range desired state or position in future.
• Goals are quantitative targets to be achieved in specified period.
• Strategies represent specific course of action to achieve goals.
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Plans/Budgets
• The final step is the preparation of budgets/profit plans.
• Basically, budgeting is the periodic planning to implement the alternatives during
a particular fiscal period, usually one year.
• It converts, in other words, goals and strategies into annual operating plans.
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Budget – Definition, Meaning and Purpose
• A budget is defined as a ‘comprehensive and coordinated plan, expressed in
financial terms, for the operations and resources of an enterprise for some
specified period in the future.
• According to this definition, the essential elements of a budget are:
 Plan,
 Operations and resources,
 Financial terms,
 Specified future period,
 Comprehensiveness, and
 Coordination.
• Plan: A budget (plan) is an expression partly of what the management expects to
happen and partly of what the management intends to happen.
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• Operations and Resources: A budget is a mechanism to plan for the firm’s
operations and resources. The operations are reflected in revenues and expenses.
• Financial Terms: Budgets are prepared in financial terms, that is, in terms of
monetary value such as the rupee, dollar, and so on.
• Specified Future Period: A budget relates to a specified period of time, usually
one year.
• Comprehensiveness: A budget is comprehensive in that all the activities and
operations of an organisation are included in it.
• Coordination: The budgets for each of the components are prepared in harmony
with each another.
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Budgets—Purpose
• As a tool, budgets serve as a guide to the conduct of operations and a basis for
evaluating actual results.
• The main objectives of budgeting are:
 Explicit statement of expectations,
 Communication,
 Coordination, and
 Expectations as a framework for judging performance.
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Preparation/ Types of Budgets
• Master budget is the overall budget for the entire organisation.
• A master budget normally consists of three types of budgets:
 Operating budgets,
 Financial budgets, and
 Special decision budgets.
• Another classification of a master budget is:
 Fixed/static budget and
 Flexible/variable/sliding budget.
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Operating Budgets
• Operating budgets relate to the physical activities/ operations of a firm such as
 sales,
 production,
 purchasing,
 debtors collection and
 creditors payment schedules.
• In specific terms, an operating budget has the following components:
 Sales budget
 Production budget
 Purchase budget
 Direct labour budget
 Manufacturing expenses budget
 Administrative and selling expenses budget, and so on.
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Financial Budgets
• Financial budgets are concerned with expected cash receipts/disbursements,
financial position and results of operations.
• In other words, a financial budget has the following components:
 Budgeted income statement,
 Budgeted statement of retained earnings,
 Cash budget, and
 Budgeted balance sheet.
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Special Decision Budgets
• The third category of budgets are special decision budgets.
• They relate to
 inventory levels,
 break- even analysis, and so on.
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Flexible Budgets
• A flexible budget estimates costs at several levels of activity.

• The merit of a flexible budget is that instead of one estimate it contains several
estimates/plans in different assumed circumstances.
• The conceptual framework of flexible budgeting, relates to:
 Measure of volume
 Cost behaviour identified with change in volume.
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Measure of Volume
• The volume measure selected for any given department/ firm should be that
quantity which displays the greatest degree of correlation with those costs that
vary with the level of operating activity.
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Cost Behaviour with Change in Volume
• Three different types of cost behaviour can be visualised with changes in
volume/level of activity:
 Fixed costs,
 Variable costs, and
 Mixed costs.
• Fixed costs are fixed for a relevant range of volume for a given budget period.
• Variable costs fluctuate in direct proportion to activity/volume within relevant
range for a given budget period.
• Mixed costs are composed of both fixed and variable elements.
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Modified Flexible Budgets
• One limitation of flexible budgets is that they do not explicitly consider the
relative probability that any particular volume or cost will be achieved.
• This limitation can be overcome by using a modified flexible budget, which will
include columns for different levels of estimates—most likely, optimistic and
pessimistic.
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Chapter 8 –

Budgeting and Profit

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• A flexible budget estimates costs at several levels of activity.

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