Chapter 6

Budgeting
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Contents
1.1. Why do organisations prepare budgets?

1.2. A framework for budgeting

1.3. Steps in the preparation of a budget

1.4. The master budget

1.5. Preparing forecasts

1.6. Alternative approaches to budgeting

1.1. Why do organisations prepare budgets?

A financial and/or quantitative

plan of operation for a
forthcoming period, expressed in
money terms

Putting your objectives into $

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The purpose of budgets

» Compel planning
» Communicate ideas and plans
» Coordinate activities
» Means of allocating resources
» Authorisation
» Provide a framework for responsibility accounting
» Establish a system of control
» Provide a mean of performance evaluation
» Motivate employees to improve their performance
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» A forecast is a prediction of what is what is likely to happen

» A budget is a quantified plan
» Budget is based on the forecast
» Budget forces management into decision making and taking
action
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Quantified budget

A budget must be quantified

The budgets provide definite plans

An important feature of any quantified budget is the fact that it is time bound.
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2. A framework for budgeting

The coordinating body in the preparation and
administration of budgets, normally headed up by
the managing director.

Main functions of the budget committee:

 Coordinating and allocation of responsibility for the preparation of budgets
 Issuing of the budget manual
 Provision of information to assist in the preparation of
 Communication of final budgets to the appropriate managers
 Monitoring the budgeting process by comparing actual and budgeted results
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Framework for budgeting

Budget period:

• Usually one year

• Some longer than one year: capital expenditure budget
• Some shorter than one year: in rapidly changing industry

Annual budget will usually be divided into monthly

control periods
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» Budget manual may contain the following:

» An explanation of the objectives of the budgetary
process
» Organizational structures
» An outline of the principal budgets and the relationship
between them
» Administrative details of budget preparation
» Procedural matters
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3. Steps in the preparation of a budget

Determining principle budget factor

The order of budget preparation

Preparing functional budgets

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Principal budget factor (PBF)

The principal budget factor is that factor which limits an
organisation's activities, usually sales demand.

» Production budget can only be prepared after the sales

budget is completed
Order of budget preparation 13
 Example 1 - ECO company 14

ECO Co manufactures two products, S and T, which use the same raw materials, D and E. One unit
of S uses 3 litres of D and 4 kilograms of E. One unit of T uses 5 litres of D and 2 kilograms of E.
A litre of D is expected to cost £3 and a kilogram of E £7.
Budgeted sales for 20X2 are 8,000 units of S and 6,000 units of T; finished goods in inventory at 1
January 20X2 are 1,500 units of S and 300 units of T, and the company plans to hold inventories of
600 units of each product at 31 December 20X2.
Inventories of raw material are 6,000 litres of D and 2,800 kilograms of E at 1 January and the
company plans to hold 5,000 litres and 3,500 kilograms respectively at 31 December 20X2.
The warehouse and stores managers have suggested that a provision should be made for damages
and deterioration of items held in store, as follows.
Product S : loss of 50 units
Product T : loss of 100 units
Material D : loss of 500 litres
Material E : loss of 200 kilograms
Requirement
Prepare a material purchases budget for the year 20X2.
 Example 2 - XYZ company 15

XYZ company produces three products, X, Y and Z.

Budgeted sales
Product X 2,000 at £100 each
Product Y 4,000 at £130 each
Product Z 3,000 at £150 each
Budgeted usage of raw material RM11 RM22 RM33
Product X 5 2 –
Product Y 3 2 2
Product Z 2 1 3
Cost per unit of material £5 £3 £4
Finished inventory budget Product X Product Y Product Z
Opening 500 800 700
Closing 600 1,000 800
Raw materials inventory budget RM11 RM22 RM33
Opening 21,000 10,000 16,000
Closing 18,000 9,000 12,000
Product X Product Y Product Z
Expected hours per unit 4 6 8
Expected hourly rate (labour) £9 £9 £9
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Example 2 - XYZ company

Sales budget

X Y z
Sales (Units) 2,000 4,000 3,000
Price per batch $100 $130 $150
Revenue $200,000 $520,000 $450,000
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Example cont.
Production budget

X Y z
Sales (Units) 2,000 4,000 3,000
Closing inventory 600 1,000 800
Opening inventory (500) (800) (700)
Production (units) 2,100 4,200 3,100

Each unit use M11 RM22 RM33

X 5 2 -
Y 3 2 2
Z 2 1 3
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Example cont.
RM budget

Production Material usage

budget
Production RM11 RM22 RM33
Units Units Units Units
X 2,100 10,500 4,200 -
Y 4,200 12,600 8,400 8,400
Z 3,100 6,200 3,100 9,300
Budgeted material usage 29,300 15,700 17,700
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Example cont.

RM budget

Material purchases
RM11 RM22 RM33
Units Units Units
Material usage 29,300 15,700 17,700
Closing inventory 18,000 9,000 12,000
Opening inventory (21,000) (10,000) (16,000)
Material purchases 26,300 14,700 13,700
Standard cost per unit $5 $3 $4
Budgeted material purchases $131,500 $44,100 $54,800
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Example cont.
Labour budget

Labour budget
Production Hours required Laboưur budget Rate/hour Cost
per unit total hours
Units
X 2,100 4 8,400 9 75,600
Y 4,200 6 25,200 9 226,800
Z 3,100 8 24,800 9 223,200
Budgeted total wages 525,600
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Budgeting vs Standard costing

To preparation of budgets, you used data about the expected

price and usage of the resources required to manufacture one
unit of product in the budget.

=> Standard costs provide the basic unit rates to be used in the
preparation of a number of functional budgets.
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4. The master budget

» The master budget consists of a 'budgeted income statement, a budgeted
statement of financial position ditopan and a cash budget.

» The master budget provides a consolidation of all the subsidiary budgets

and is likely to be of most interest to senior managers and directors

» Sensitivity analysis might be carried out on the master budget to show the
effect on the budgeted outcome of changes in the budgeted assumptions.
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The master budget

Simple example:
Use the following information to prepare a budgeted income statement for the six months ended
30 June and a budgeted balance sheet at that date.
A new business is to be started and details of budgeted transactions are as follows.
• Non-current assets will be purchased for £12,000. Depreciation will be charged on a straight
line basis, assuming that the assets will have a useful life of five years after which they will
have no residual value.
• Month-end inventories will be maintained at a level sufficient to meet the forecast sales for
the following month.
• Forecast monthly sales are £4,000 for January to March, £5,000 for April to June and £6,000
per month for July onwards.
• The gross profit margin is budgeted to be 20% of sales value.
• Two months' credit will be allowed to customers and one month's credit will be received from
suppliers of inventory.
• Operating expenses (excluding depreciation) are budgeted to be £350 each month.
• The budgeted closing cash balance as at 30 June is £16,700.
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What – if analysis

• The sensitivity of the budget outcomes to changes in the

budget assumptions.
• For example:

• What will be the budgeted profit if sales revenue is 5%

higher or lower than the budget?
• A sensitivity analysis can be called as 'what if?' analysis.
 Sensitivity analysis 25

R Ltd manufactures and sells a single product. The budgeted income statement
contained in the master budget for the forthcoming year is as follows.

£ £
Sales revenue (20,000 units) 640,000
Variable materials cost 190,000
Variable labour cost 172,000
Variable overhead 13,000
Fixed overhead 155,000 530,000
Budgeted net profit 110,000

The directors wish to know what the budgeted profit will be if a higher quality
material is used. This will increase material costs per unit by 10% but sales
volume will be increased by 5%. There will be no change in the unit selling price.
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Sensitivity analysis
Assumptions
The budgeted sales volume will increase to 21,000 units and, in the absence of
information to the contrary, we will assume there will be no changes in the total
fixed overhead cost incurred and no changes in the variable labour and overhead
costs per unit. The revised budgeted income statement will look like this.

£ £
Sales revenue (£640,000/20,000) * 21,000 672,000
Variable materials cost (£190,000/20,000) * 1.1 21,000 219,450
Variable labour cost (£172,000/29,000) * 21,000 180,500
Variable overhead (£13,000/20,000) * 21,000 13,650
Fixed overhead 155,000 568,700
Budgeted net profit 103,300

Budgeted net profit

The proposed changes are not worthwhile since the contribution from the increase
in sales volume is not sufficient to compensate for the increase in material costs.
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5. Preparing forecast
Techniques that use past data to forecast future events assume
that the past will provide a good indication of what will
happen in the future.
• High-low method

• Linear regression
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Linear relationships
A linear relationship can be expressed in the form of an equation
that has the general form:
Y= a + bx
• X, Y are variables
• a, b are estimated using pairs of data for X and Y
» Y is the dependent variable, depending for its value on the
value of X
» X is the independent variable whose value helps to determine
the corresponding value of Y. Time is usually independent
variable.
 High-low method 29

Step1: Review records of costs in previous periods to select the period with the
highest activity level and with the lowest activity level

• Determine the total cost at high activity level and the total units at high level

• Determine the total cost low activity level and the total units at low level

Step 2: (Total Cost at high level- Total Cost at low level)/(Total units at high level -
Total units at low level) = Variable cost per unit

Step 3: Fixed Cost = Total cost at high level - (Variable cost/ Unit * Total Units at
high level)

Step 4: The linear equation y = a + bx can be used to predict - the cost for a given
activity level
 High-low method 30

The costs of operating the maintenance department of a computer

manufacturer, Bread and Butter Ltd, for the last four months have been as
follows.
Month Cost Production volume
£ Units
1 110,000 7,000
2 115,000 8,000
3 111,000 7,700
4 97,000 6,000
Requirement
Calculate the costs that should be expected in Month 5 when output is
expected to be 7,500 units. Ignore inflation.
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High low method with stepped fixed cost

Activity level (Units) Cost ($)
4,000 40,800
6,000 50,000
7,500 54,800

Variable cost per unit is constant within this activity range and there is a
step up cost of 10% in the total fixed costs when the activity level exceeds
5,500 units

Required: what is the total cost at the activity level of 5,000 units
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High low method with changes in variable cost

Activity level (Units) Cost ($)

200 7,000
300 8,000
400 8,600

For output volume of above 350 units, the variable cost. per units falls by 10%.
(Note that this fall applies to all units, not just the excess).

Required: what is the total cost at the activity level of 450 units.
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Linear regression analysis

» Linear regression analysis is a statistical technique for establishing a

straight line equation to represent a set of data.

» Linear regression analysis is superior than the high-low method

» The quality or reliability of the linear equation derived will depend upon
the correlation between the variables.
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Correlation
• Cofrelation: Two variables are said to be correlated if a change in value of
one variable is accompanied by a change in value of other variable.

• For example: Sales and unit sold, the distance and the time it takes

• Using Scatter diagram to show the correlation

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Degree of correlation
• Perfectly correlated: All the pairs value on a straight line → exact linear
relationship
• Partly correlated:
✓Although there is no exact relationship, low value of X to be associated
with low value of Y or high value of X with high value of Y
✓Again, no exact relationship, but low value of X to be associated with high
value of Y and vice versa.
• Uncorrelated: There are two variable but not correlated with other
• Non-linear or curvilinear correlation: a curve, not a linear
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Positive or negative correlation

Correlation can be positive or negative.

+ Positive correlation: low values of one variable are associated with low
values of the other, and high values of one variable are associated with high
values of the other.

+ Negative correlation: low values of one variable are associated with high
values of the other, and high values of one variable with low values of the
other.
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Correlation coefficient
»The correlation between two variables can be measured by the correlation
coefficient
r=
Where
X and Y represent pairs of data for two variables X and Y
n = the number of pairs of data used in the analysis
• “r” has a value between –1 (perfect negative correlation) and +1 (perfect
positive correlation).
• The nearer “r” is to +1, -1, the stronger relationship.
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Correlation coefficient (Cont.)

The coefficient correlation values between - 1 and +1 where:

• r = +1 means perfectly positive correlation: low value of one

variable associated with low value of other

• r = -1 means perfectly negative correlation: low value of one

variable associated with high value of other

• r = 0 means uncorrelated

• Using graph to identify “r". (Scatter diagram)

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Coefficient of determination, r2
• r2 (r-squared) measures the proportion of the total variation in the value of
one variable that can be explained by the variations in the value of other
variable
• Example: if correlation coefficient between output and maintenance cost r =
0.9, r2 = 0.81 which would mean that 81% of the variations of maintenance
cost could be explained by the variations of the output leaving 19% which is
due to other factors (such as the age of the machines)
Notes that we say 81% Y could be explained X (not caused by X)
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6. Alternative approaches to budgeting

Participation in budgeting process

» The participation in the budgeting process will improve motivation and

so will improve the quality of budget decisions and the efforts of
individuals to achieve their budget targets.

» There are basically two ways:

• Top-down (imposed budget) )

• Bottom-up (participatory budget)

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Top-down budgeting
» Top management prepare a budget with little or no input from operating
personnel which is then imposed upon to the employees who have to
work to the budgeted figures.
» This style of budgeting in effective in:
• In newly-formed organizations
• Very small business
• During periods of economic hardship
• Lack of budgeting skills
• When the organization's different units require precise coordination
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Bottom - up budgeting
» Budgets are developed by lower level managers who then submit the
budgets to their superiors. The budgets are based on the lower level
managers’ perceptions of what is achievable and the associated necessary
resources.
» Participatory budget are effective in:
• Well established organizations
• Well large businesses
• During periods of economic affluence
• Managers have strong budgeting skills
• Organization’s different units act autonomously
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Incremental budgeting

 Start with the previous period’s budget or actual results and add
(or subtract) an incremental amount to cover inflation and other
known changes.
 Suitable for stable businesses where costs are not expected to
change significantly. There should be good cost control and
limited discretionary costs.
 Zero based budgeting
» Under ZBB, budget for each cost centre should be made from scratch" or
zero.
» There are three steps
• Define decision packages
• Evaluate and rank packages
• Allocate resources
» Favourable conditions
• Budgeting for discretionary costs
» Disadvantage
• Time
• A great deal of work
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Zero based budgeting

Zero based budgeting vs. incremental budgeting

Start with a clean sheet Base on current year

Next year's budget is zero

Add on % for growth/inflation
• Advantages:
• Easy to prepare
• Disadvantages
• Inefficient
• Budgetary slack
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Periodic budgets

• The budgets is prepared for typically one year at a time.

No alterations once the budget has been set.

• Suitable for stable businesses where forecasting is easy and where

tight control is not necessary
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Rolling (continuous) budgets

• A budget kept continuously up to date by adding another

accounting period when the earliest period has expired.

• Aim: to keep tight control and always have an accurate budget for
the next 12 months.

• Suitable if accurate forecasts cannot be made, or if need tight

control.
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Rolling (continuous) budgets

Advantages Disadvantages

Reduce the element of uncertainty More time, effort and money

Force managers to reassess the Off-putting effect on managers (doubt

budget regularly the value of preparing one budget)

Planning and control will be based on

a recent plan

There is always a budget that extends

for several months ahead.
 Alternative budget structure
• Product based budgets: are drawn up by preparing separate budgets for
each product.
=> appropriate when the cost and revenue responsibilities differ for
each product, or when a single manager is responsible for all aspects of one
product.
• Responsibility based budgets: segregate budgeted revenues and costs into
areas of personal responsibility in order to assess the performance of each
part of an organization
• Activity based budgets (ABB): are based on a framework of activities, and
cost drivers are used as a basis for preparing budgets.