Chapter Three

Information for Budgeting,

Planning And Control Purpose
 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.
Budget is the most widely used means for planning and
controlling activities at every level of an organization.
 Planning involves developing goals and preparing
various budgets to achieve those goals.
 Controlling involves gathering feedback to ensure that
the plan is being properly executed or modified as
circumstances change.
 Budget - a detailed financial document that
translates the company’s objectives into financial
terms.
 It identifies the resources and expenditures that will
be required over a limited planning horizon
(typically a year), which can be broken into shorter
periods (for example, months or quarters).
Budgeting is a proactive approach rather than a
reactive approach to managing resources.
 Budgeting makes it easier for governments,
government departments, businesses and
individuals with incomes and expenses of all sizes
to make conscious decisions about how they will
prefer to allocate their resources. Therefore,
Budgeting: is the act of preparing a budget
 Budgeting is the complete process of designing,
implementing and operating budgets.
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.
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.
Benefits of Budgeting
 Force managers to look ahead and state their goals for
the future and address potential problems.
 Communicate management’s plans throughout the
organization.
 Coordinate the activities of the entire organization by
integrating the plans of its various parts.
 Define goals and objectives that can serve as
benchmarks for evaluating subsequent performance.
 Providing motivation for employees to work toward
organizational objectives.
 Principal budget factor: Major constraints/limiting
factors/bottlenecks. E.g: sale, materials, labor, Availability of capacity.
Budgeting and Behavioral Influences
• The way in which managers and employees
behave in response to budgets depends, in
large part, on how goals and budgets are
set.
• Two considerations are especially critical:
the relative difficulty of meeting goals and the
degree of employee participation in
establishing goals.
managers must try to find the “just-right”
level of difficulty in setting budgetary goals.
- Budgets that are tight but attainable are
more likely to motivate people than
budgets that are either too easy or too difficult
• Participative budgeting: allows
employees throughout the organization to have
input into the budget-setting process.
• Budgetary slack: the employees can do
so by understating expected sales or
overstating budgeted expenses, making it
more likely that they will look good by
coming in under budget for expenses or
over budget for revenues.
Quantitative aids in budgeting: learning curve
theory and application
Activity-based budgeting
 Activity-based budgeting (ABB) is a method of
budgeting where activities that incur costs are
recorded, analyzed and researched.
 It is more rigorous than traditional budgeting processes,
which tend to merely adjust previous budgets to account
for inflation or business development.
 It is a method which management prepares annual budget
based on next year’s activity. It is depended on the
activities based costing, which analyzes all variable and
overhead costs associate with activities, the non-value
added cost will not be included.
To Demonstrate how ABB can be implemented, it is useful
to compare it to a traditional budgeting method.
 Suppose Company ABC expects to sell 1,000 units of
its product over the next month, and the product costs $5
to produce. Under activity-based budgeting, the
company will estimate the cost of goods sold to be
$5,000.
 Also, assume Company ABC reported a cost of goods
sold at $4,000 last month, with the rate of increase
averaging 10% each month in the past. Under the
traditional budgeting method, the company will estimate
the cost of goods sold in the upcoming month to
be $4,400 [$4,000 + ($4,000 x 10%)].
Control theory and budgeting,
 CIMA,London, defines Budgetary Control as: “The
establishment of budgets relating the responsibilities of
executives to the requirements of policy and the continuous
comparison of actual with budgeted results either to
 secure by individual action, the objective of that
policy or
 to provide a basis for its revision.”
 Budgetary Control means laying down monetary and
quantitative terms of what exactly has to be done, how it is
to be done, the actual results should not deviate much
from the budgeted results, a course of action if results
deviate and also fixing the responsibilities for various levels
of management.
OBJECTIVES/USES OF BUDGETARY CONTROL
• to achieve the targets set for the company.
• to fix the responsibilities of executives, departments and
personnel.
• comparison purpose.
• to ensure the best use of all available resources.
• the purpose of co-ordination.
• revision purpose.
• for long range plans.
• To reduce losses and wastes to the minimum.
• to remedy the situation.
• It motivates employees
• It communicates goals of the organization to the
employees.
ADVANTAGES OF BUDGETARY CONTROL SYSTEM
A. enables the management of a business concern to conduct
its business activities in the efficient manner.
B. for the control of their expenditure.
C. It provides a yardstick for measuring and evaluating the
performance of their individuals and their departments.
D. It helps in the review of current trends and framing of
future policies.
E. It inculcates the feeling of cost consciousness among
workers.
F. Management which have developed a well ordered budget
plans and which operate accordingly, receive greater favor
from credit agencies.
LIMITATIONS OF BUDGETARY CONTROL SYSTEM
1. Based on estimates: Budgets may or may not be true as
they are based on 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. Time factor: Management must not expect too much
during the development period.
3. Co-operation required: Staff co-operation is usually
not available during budgetary control exercise.
4. Expensive: No budgetary program can be successful
unless adequate arrangements are made for supervision
and administration.
5. Not a substitute for management: Budget is only a
managerial tool. It cannot substitute management.
Uncertainty and budgeting
 Uncertainty can take many forms, It may manifest as a
natural disaster, the deterioration of a foreign currency in
which your company has operations, geo-political
changes, the merger or acquisition of a competitor or a
global pandemic.
 Regardless of form, uncertainty does illuminate a certain
truth: companies must face volatile business conditions
with nimble planning, budgeting and forecasting.
 Most companies find budgeting a challenge even under
stable conditions.
 When economic forecasts fluctuate on a weekly or even
daily basis, creating one reliable budget to coordinate
business units and track performance for an entire fiscal
year is extraordinary.
3.2. BUDGETING IN THE CONTEXT OF
CONTROL SYSTEM THEORY
 A control system consists of a sensor which reports information (a
monthly operating statement).
 A comparator which measures performance (comparison of actual
with budget and identification of variances).
 An effector (management action to correct identified deficiencies
or opportunities).
ALTERNATIVE BUDGET SYSTEMS:
 Incremental budgeting
 Zero based
 Rolling
 Types, based on:
Activity Flexibility Time
Operating Static/fixed short term,
1. INCREMENTAL BUDGETING
The traditional approach to budgeting,
known as incremental budgeting, bases
the budget on the current year's results
plus an extra amount for estimated
growth or inflation next year.
It concerned mainly with the
increments in costs and revenues which
will occur in the coming period.
It may be reasonable procedure if
current operations are as effective,
efficient and economical as they can
be.
 It is also appropriate for budgeting for costs
such as staff salaries, which may be
estimated on the basis of current salaries
plus an increment for inflation and are hence
administratively fairly easy to prepare.
 it is an inefficient form of budgeting as it
encourages slack and wasteful spending to
creep into budgets.
 Past inefficiencies are perpetuated because
cost levels are rarely subjected to close
investigation.
ADVANTAGES OF INCREMENTAL
BUDGETS
 Quickest and easiest method of budgeting.
 Suitable for organizations that operate in a
stable environment where historical figures
are reliable and are not expected to change
significantly.
DISADVANTAGES
 Builds in previous problems and inefficiencies.
 Uneconomic activities may be continued.
For example, a car manufacturer may continue
to make parts in-house when it may be
cheaper to outsource.
2. ZERO BASED BUDGETING
Preparing a budget for each cost centre from a zero
base.
Every item of expenditure has then to be justified
in its entirety in order to be included in the next
year's budget.
In this way, every aspect of the budget is examined
in terms of its cost and the benefits it provides and
the selection of better alternatives is encouraged.
ZBB rejects the assumption inherent in incremental
budgeting.
ADVANTAGES OF IMPLEMENTING ZBB
• It is possible to identify and remove inefficient or
obsolete operations.
• It forces employees to avoid wasteful expenditure.
• It can increase motivation.
• It responds to changes in the business environment.
• It results in a more efficient allocation of resources.
DISADVANTAGES
 It requires a lot of management time and paperwork.

Short-term benefits might be emphasized to the

detriment of long-term benefits.
Management must be able to meet unforeseen
opportunities and threats at all times.
Managers may have to be trained in ZBB techniques.
 It is difficult to rank activities which have qualitative
rather than quantitative benefits – such as spending on
staff welfare and working conditions.
3. ROLLING BUDGETS : DYNAMIC
CONDITIONS
• Rolling budgets (continuous budgets)
are budgets which are continuously updated
by adding a further period (say a month or a
quarter) and deducting the earliest period.
• Are suitable to organizations that operate in
Dynamic (Volatile) conditions.
 Actual conditions may differ from those
anticipated when the budget was drawn up for
a number of reasons as follows:
 Organizational changes may occur.
 A change in structure, from a functional basis, say, to
a process-based one.
 New agreements with the workforce about flexible
 The reallocation of responsibilities following,
say, the removal of tiers of middle
management and the 'empowerment' of
workers further down the line.
 Action may be needed to combat an
initiative by a competitor.
 New technology may be introduced to
improve productivity, reduce labor
requirements or enhance quality.
 Rolling budgets are an attempt to prepare
targets and plans which are more realistic
and certain, particularly with a regard to
price levels, by shortening the period
between preparing budgets.
for example, that a rolling budget is
prepared every three months;
The first three months of the budget
period would be planned in great detail,
and the remaining nine months in lesser
detail,
This is because of the greater
uncertainty about the longer-term
future.
THE ADVANTAGES OF ROLLING BUDGETS
 They reduce the element of uncertainty in
budgeting because they concentrate detailed
planning and control on short-term prospects
where the degree of uncertainty is much smaller.
 They force managers to reassess the budget
regularly, and to produce budgets which are up
to date in the light of current events and
expectations.
 Planning and control will be based on a recent
plan which is likely to be far more realistic than
a fixed annual budget made many months ago.
 Realistic budgets are likely to have a better
motivational influence on managers.
• There is always a budget which extends for
several months ahead.
THE DISADVANTAGES OF ROLLING BUDGETS
They involve more time, effort and
money in budget preparation.
Frequent budgeting might have an off-
putting effect on managers who doubt
the value of preparing one budget after
another at regular intervals.
Revisions to the budget, standard costs
and to stock valuations might involve.
This could replace a large administrative
effort from the accounts department
every time a rolling budget is prepared.
4. FIXED AND FLEXIBLE BUDGETS
 A fixed budget - is a budget which is set for
a single activity level and It remains
unchanged regardless of the level of activity.
 A flexible budget- is a budget which
recognizes different cost behavior patterns
and is designed to change as volume of
activity changes.
 They are designed to flex with the level of
activity.
 Flexible budgets are prepared using marginal
costing and so mixed costs must be split into
their fixed and variable components.
• The fixed budget‘s main purpose is to serve as a
benchmark in performance evaluation.
• It seeks to define the broad objectives of the
organization.
• It is normally set prior to the start of an accounting
period, and which is not changed in response to
changes in activity or costs/revenues.
• Fixed budgets(in terms of a pre-set expenditure
limit) are also useful for controlling any fixed cost,
and particularly non-production fixed costs such as
advertising ,because such costs should be unaffected
by changes in activity level(within a certain range).
3.3.Monitoring and controlling performance in
budgeting
 All departments are required to regularly monitor actual
activity to planned activity and control their expenditure
to ensure that it is in line with available funds.
 Comparing your business budget year-on-year with your
actual performance can be a good way of benchmarking
how your business is performing.
 If required, appropriate corrective action should be taken
to resolve significant differences between actual and
planned activity.
 The financial jargon for this process of monitoring income
and expenditure and taking corrective action is budgetary
control.
 3.4.Master Budget
• The master budget is the aggregation of all lower-level budgets
produced by a company's various functional areas, and also
includes budgeted financial statements, a cash forecast, and a
financing plan.
• Master budget is a comprehensive financial planning document
that consists of capital expenditure and a set of interrelated
operating and financial budgets.
 Capital expenditure budget- covers long term
asset and project costs.
 Operating budget ( profit plan) - Focuses on the
income statement and supporting schedules or
budgeted expenses.
 Financial budget - Focuses on the effects that the
operating budget and other plans will have on cash
balances. It deals with cash flows and financial data
of a company.
Learning
Objective Steps in Preparing the Master Budget

1. Supporting data

2. Operating budget

3. Financial budget
 Order of components of master budget

Since the components of master budget are

interconnected, it requires some flow of data
among budgets.
Meaning:
one component budget flow to another
one.
components are prepared in a specific
order.
 Master budget in
manufacturing firms
Exhibit 9.4 below delineates the
relationships among components of a
master budget for a hypothetical
manufacturing firm.
 Sales budget
 It is the first and basic components of Master budget.
 Shows total sales forecasted during the period.
 The products of expected sales in units and expected
price per unit.
 Accompanied by a schedule of expected cash
receipts.
 Method of forecasting sales: Delphi, Trend Analysis
& Mkt research:
Illustration:
 The Hampton Freeze planed to have quarterly unit
sales of 10,000, 30,000, 40,000 & 20,000 and 20 $
for each case.
 Hampton Freeze Inc
Sales Budget
For the Year Ended December 31, 2008
Quarters
1 2 3 4 Year
Budgeted sales 10,000 30,000 40,000 20,000 100,000
Selling price $ 20 $ 20 $ 20 $ 20 $ 20
Total Sales 0.2 m 0.6m 0.8m 0.4m 2m
 Schedule of Expected Cash Collections
Shows the budgeted collections on sales during a period.
 As %ge of budgeted sales.
 Prepared after sales budget and before cash budget.
 Ignores bad debts.
Illustration:
 Hampton Freeze assumes beginning A/R amounts $
90,000 & 70 % of sales are collected in the period(quarter)
sale is made and the remaining is to be collected in the
following quarter.
 Production Budget
 It shows planned production in units for a given period.
 It is prepared based on sale budget data.
Manufacturing Merchandising
Budgeted sales units Budgeted sales units
+ Ending Units * + Ending Units *
− Beginning in Units − Beginning in Units
Planned Prod. in Units Planned Purchase in Units
*Endings for the current period are beginnings for the next
period .
Illustration: A company assumes an ending
inventory equal to 20% of the next quarter’s sales. Beginning
inventory of the 1st quarter and ending inventory of 4th
quarter is assumed 2,000 & 3, 000 units respectively.
 The Direct Materials Budget
 It shows the quantity of direct material that will be used in
production.
 Formula:
Budgeted Production during the Period
× Units of Direct Material Required per Unit
= Direct Material in Units Needed for Production
+ Budgeted Ending DM
− Beginning Direct Material
= Budgeted DM Purchases in units
× Cost per DM
= Budgeted DM Purchases in Birr
illustration: The company planned to have an ending inventories
equal to 10% of the following
quarter’s production needs & each requires 15 pounds of sugar
(DM for each unit to be produced)& each costs 0.2 $ per unit.
.
 Schedule of Expected Cash Payments

 shows the budgeted payments on purchase during a

period.
 As percentage of budgeted purchases
 prepared after DM purchase budget and before cash
budget.
Illustration:
 At Hampton Freeze, the policy is to pay for 50 % of
purchases in the quarter in which the purchase is made
and 50% in the following quarter. Beginning A/p amounts
$ 25,800.
 The Direct Labor Budget
Shows the direct labor-hours required to satisfy
the production budget.
Formula:
Planned Production in units
× Direct Labor Hours Required per Unit
= Budgeted Direct Labor Hours Required
× Cost per DL Hours
= Budgeted Direct Labor Cost
Illustration:
 The company expects each case requires 0.40
direct labor-hour & each costs $15 per direct
labor-hour
•
 Factory Overhead Budget

• Shows all the planned manufacturing costs, other than direct costs,
needed to produce the budgeted production level.
• It has two sections: variable and fixed OH costs.
 Two alternatives to prepare OH budget
1. 2.
Total Fixed OH Total Fixed OH
+ Total Variable OH + Variable OH(V.OH rate X
=Total OH Assumed variable OH Units)

− Depreciation = Total OH
= Cash Pay’t for FOH − Depreciation
= Cash Pay’t for FOH
Illustration:
 Variable OH $ 4 per DL-hour and the fixed OH costs is $60,600
per quarter. Depreciation = $ 15,000 per quarter
 Selling and Administrative Expense Budget
• Shows planned operating expenses other than manufacturing costs.
• Common in all businesses
• Formula:
Budgeted sales
X variable selling & Adm expense per unit
= total variable selling & Administration expense
+ Total fixed selling & Adm expense
= Total selling & Administration expense
- Depreciation
= Cash Pay‘t for selling & Administration expense
Illustration:
Variable OH costs $1.8 per DL-hour and the total fixed OH
costs is $ 99,000 per quarter. Depreciation = $ 10,000 per
quarter
 cash budget
 The cash budget is composed of four major sections:
1. The receipts section.
2. The disbursements section
3. The cash excess/deficiency section.
4. The financing section.
Format
Cash balance, beginning . . . . . . . . . . . . . . . . . . . . . . . . . XXXX
Add receipts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXXX
Total cash available . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXXX
Less disbursements . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . XXXX
Excess/deficiency of cash available over payments . . . . XXXX
Illustration:
 Beginning cash balance $ 42,500 borrowings at the beginning
of 1st & 2nd quarters $ 130,000 & $ 70,000 respectively.
 Budgeted Income Statement
shows planned profit :
for trading and profit and loss accounts
The budgeted trading account is to disclose the
budgeted gross profit,
while the budgeted profit and loss account is to
disclose the budgeted net profit before tax.
serves as a benchmark for operating performance
measurement.
Illustration:
 Hint: Consider the total sale value , CGS , Selling
& administrative expenses and interest expense,
so as to prepare the Budgeted Income Statement.
Budgeted Income Statement
 The Budgeted Balance Sheet

It is developed using data from the balance sheet

from the beginning of the budget period and data
contained in the various schedules. fore instance,
cash budget.
Illustration:
 Hampton Freeze’s budgeted balance sheet is presented using
data taken from the company’s previous end-of-year balance
sheet for 2007, which appears below:
Budgeted balance sheet
 MASTER BUDGET in Merchandising Firms
 A merchandising firm does not have a production bud-
get; instead, it prepares a merchandise purchases
budget.
 A merchandise purchases budget shows the amount of
merchandise needs to purchase during the period.
 The basic format of a merchandise purchases budget is
the same as the production budget. however, the last
items in a merchandise purchases budget are bud-
geted purchases instead of budgeted production.
 Budgeting in service companies
 Service companies have different characteristics and concerns in
budgeting than those of manufacturing and merchandising firms.
• Similar to budgeting for manufacturing or merchandising firms,
budgeting for service firms consists of an integrated set of plans
for an upcoming period
• A service organization achieves its budgeted goals and fulfills its
mission through providing services.
• Therefore, an important focal point in its budgeting is personnel
planning and a service firm must ensure that it has personnel with
the appropriate skills to perform the services required for the bud-
geted service revenue.
 THE END!!
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