Cost and Management Accounting II

Chapter One
Budgeting for Planning and Control

Careful planning is vital to the health of any organization. Failure to plan, either formally or
informally, can lead to financial disaster. Managers of businesses, whether small or large, must
know their resource capabilities and have a plan that details the use of these resources. In this
chapter, the basics of budgeting are discussed, and traditional master budgets using functional-
based accounting data are developed. Flexible and activity-based budgeting is also presented.
The Role of Budgeting in Planning and Control
Budgeting plays a crucial role in planning and control. Plans identify objectives and the actions
needed to achieve them.
 Budgets are the quantitative expressions of these plans, stated in either physical or
financial terms or both. When used for planning, a budget is a method for translating the
goals and strategies of an organization into operational terms.
 Control is the process of setting standards, receiving feedback on actual performance, and
taking corrective action whenever actual performance deviates significantly from planned
performance. Thus, budgets can be used to compare actual outcomes with planned
outcomes, and they can steer operations back on course, if necessary.

Purposes of Budgeting
Budgets are usually prepared for areas within an organization (departments, plants, divisions,
and so on) and for activities (sales, production, research, and so on). This system of budgets
serves as the comprehensive financial plan for the organization as a whole and gives an
organization several advantages.
1. It forces managers to plan.
2. It provides resource information that can be used to improve decision making.
3. It aids in the use of resources and employees by setting a benchmark that can be used for
the subsequent evaluation of performance.
4. It improves communication and coordination.
Every organization must have someone responsible for directing and coordinating the overall
budgeting process. This budget director is usually the controller or someone who reports to the
controller. The budget director works under the direction of the budget committee. The budget
committee has the responsibility to:-
 Review the budget
 Provide policy guidelines and budgetary goals
 Resolve differences that may arise as the budget is prepared
 Approve the final budget, and
 Monitor the actual performance of the organization as the year unfolds. The budget
committee is also responsible for ensuring that the budget is linked to the strategic
plan of the organization.
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The president of the organization appoints the members of the committee, who are usually the
president, vice presidents, and the controller.
Budget type
 Appropriation budget:- a maximum amount is established for certain expenditures
based on management judgment.
 Flexible budget:- a static amount (a) is established for fixed costs and a variable
rate (b) is determined per activity measures for variables costs i.e Y=a+bx
 Capital budget: - Decisions concerning potential investments are made using
discounted cash flow techniques.
 Master Budget:- A comprehensive plan is developed for all revenue and
expenditure.
The master budget is a comprehensive financial plan for the year made up of various individual
departmental and activity budgets. A master budget can be divided into operating and financial
budgets.
Operating budgets are concerned with the income generating activities of a firm: sales,
production, and finished goods inventories. The ultimate outcome of the operating budgets is a
pro forma or budgeted income statement. Note that “pro forma” is synonymous with “budgeted”
and “estimated.” In effect, the pro forma income statement is done “according to form” but with
estimated, not historical, data.
Financial budgets are concerned with the inflows and outflows of cash and with financial
position. Planned cash inflows and outflows are detailed in a cash budget, and expected financial
position at the end of the budget period is shown in a budgeted, or pro forma, balance sheet.
Gathering Information for Budgeting
At the beginning of the master budgeting process, the budget director alerts all segments of the
company to the need for gathering budget information. The data used to create the budget come
from many sources. Historical data are one possibility. For example, last year’s direct materials
costs may give the production manager a good feel for potential materials costs for next year. Still,
historical data alone cannot tell a company what to expect in the future.
The sales forecast is the basis for the sales budget, which, in turn, is the basis for all of the other
operating budgets and most of the financial budgets. Accordingly, the accuracy of the sales
forecast strongly affects the soundness of the entire master budget.
Creating the sales forecast is usually the responsibility of the marketing department. One
approach is for the chief sales executive to have individual salespeople submit sales predictions,
which are aggregated to form a total sales forecast. The accuracy of this sales forecast may be
improved by considering other factors such as:-
 The general economic climate
 Economic trends in the company’s industry/ Competition
 Political and legal events
 Advertising
 Pricing policies, and so on.
Some companies supplement the marketing department forecast with more formal approaches,
such as time-series analysis, correlation analysis, econometric modeling, and industry analysis.
Preparing the Operating Budget
The first section of the master budget is the operating budget. The following are the components
of the operating budget.
1. Sales budget
2. Production budget
3. Direct materials purchases budget
4. Direct labor budget
5. Overhead budget
6. Ending finished goods inventory budget
7. Cost of goods sold budget
8. Marketing expense budget
9. Research and development expense budget
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 10. Administrative expense budget
11. Budgeted income statement

1. Sales budget
The starting point in preparing of the master budget is Sales budget. The sales budget is the
projection approved by the budget committee that describes expected sales for each product in
units and dollars. All others items in the master budget depend on it in some way.
Budgeted Sales ($) = (Budgeted unit sales) (Budgeted Sales Prices)
Current period cash collection= current period cash Sales + current Period credit
sales collected in current Period+ Prior period credit sales collected in current period

Schedule 1 illustrates the sales budget for ABT’s concrete block line. (For a multiple-product firm,
the sales budget reflects sales for each product in units and sales dollars.) Notice that the sales
budget reveals that ABT’s sales fluctuate seasonally. Most sales (75 percent) take place in the
spring and summer. Also, note that ABT expects price to increase from $0.70 to $0.80 in the
summer quarter. Because of the price change within the year, an average price must be used for
the column that describes the total year’s activities ($0.75 = $12,000/16,000 units).

2. Production Budget
The production budget describes how many units must be produced in order to meet sales needs
and satisfy ending inventory requirements. From Schedule 1, we know how many concrete blocks
are needed to satisfy sales demand for each quarter and for the year. If there were no inventories,
the concrete blocks to be produced would just equal the units to be sold. In the JIT firm, for
example, units sold equal units produced, since a customer order triggers production.
Usually, however, the production budget must consider the existence of beginning and ending
inventories. Assume that ABT company policy sets desired ending inventory of concrete blocks for
each quarter as follows.

To compute the units to be produced, we must know both unit sales and units in desired finished
goods inventory.
Units to be produced =Units, ending inventory + Unit sales - Units, beginning inventory
The formula is the basis for the production budget in Schedule 2. Notice that the production
budget is expressed in terms of units; we do not yet know how much they will cost.

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3. Direct Materials Purchases Budget
After the production schedule is completed, budgets for direct materials, direct labor, and
overhead can be prepared. The direct materials purchases budget is similar in format to the
production budget; it is based on the amount of materials needed for production and the
inventories of direct materials.
Expected direct materials usage is determined by the input-output relationship (the technical
relationship existing between direct materials and output). This relationship is often
determined by the engineering department or the industrial designer.
For example, one lightweight concrete block requires approximately 26 pounds of materials
(cement, sand, gravel, shale, pumice, and water). The relative mix of these ingredients is fixed for
a specific kind of concrete block. Thus, it is fairly easy to determine expected usage for each
material from the production budget by multiplying the amount of material needed per unit of
output times the number of units of output. Once expected usage is computed, the purchases (in
units) are computed as follows:
Purchases= Desired ending inventory of direct materials + Expected usage - Beginning
inventory of direct materials
The quantity of direct materials in inventory is determined by the firm’s inventory policy. ABT’s
policy is to have 2,500 tons of materials (5 million pounds) in ending inventory for the third and
fourth quarters and 4,000 tons of materials (8 million pounds) in ending inventory for the first
and second quarters. The direct materials purchases budget for ABT is presented in Schedule 3.
For simplicity, all materials are treated jointly (as if there were only one material input). In reality,
a separate schedule would be needed for each kind of material.

4. Direct Labor Budget

The direct labor budget shows the total direct labor hours needed and the associated cost for the
number of units in the production budget. As with direct materials, the usage of direct labor is
determined by the technological relationship between labor and output. For example, if a batch of
100 concrete blocks requires 1.5 direct labor hours, then the direct labor time per block is 0.015
hour. Assuming that the labor is used efficiently, this rate is fixed for the existing technology. The
relationship will change only if a new approach to manufacturing is introduced.
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Given the direct labor used per unit of output and the units to be produced from the production
budget, the direct labor budget is computed as shown in Schedule 4. In the direct labor budget,
the wage rate used ($8 per hour in this example) is the average wage paid the direct laborers
associated with the production of the concrete blocks. Since it is an average, it allows for the
possibility of differing wage rates paid to individual laborers.

5. Overhead Budget
The overhead budget shows the expected cost of all indirect manufacturing items. Unlike direct
materials and direct labor, there is no readily identifiable input-output relationship for
overhead items.
Recall, however, that overhead consists of two types of costs: variable and fixed. Past
experience can be used as a guide to determine how overhead varies with activity level. Items that
vary with activity level are identified (e.g., supplies and utilities), and the amount that is expected
to be spent for each item per unit of activity is estimated. Individual rates are then totaled to
obtain a variable overhead rate. For ABT, assume that the variable overhead rate is $8 per direct
labor hour. Since fixed overhead does not vary with the activity level, total fixed overhead is
simply the sum of all amounts budgeted. Assume that fixed overhead is budgeted at $1.28 million
($320,000 per quarter). Using this information and the budgeted direct labor hours from the
direct labor budget, the overhead budget in Schedule 5 is prepared.

6. Ending Finished Goods Inventory Budget

The ending finished goods inventory budget supplies information needed for the balance sheet
and also serves as an important input for the preparation of the cost of goods sold budget. To
prepare this budget, the unit cost of producing each concrete block must be calculated using
information from Schedules 3, 4, and 5. The unit cost of a concrete block and the cost of the
planned ending inventory are shown in Schedule 6.

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7. Cost of Goods Sold Budget
Assuming that the beginning finished goods inventory is valued at $55,000, the budgeted cost of
goods sold schedule can be prepared using Schedules 3, 4, 5, and 6. The cost of goods sold
schedule (Schedule 7) will be used as an input for the budgeted income statement.

8. Marketing Expense Budget

The next budget to be prepared—the marketing expense budget—outlines planned expenditures
for selling and distribution activities. As with overhead, marketing expenses can be broken into
fixed and variable components. Such items as sales commissions, freight, and supplies vary with
sales activity. Salaries of the marketing staff, depreciation on office equipment, and advertising
are fixed expenses. The marketing expense budget is illustrated in Schedule 8.

9. Research and Development Expense Budget

ABT, Inc., has a small research and development group that works on product line extensions, for
example, brick and paving tile. The expenditures by this group are estimated for the coming year

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and presented in the research and development expense budget. This budget is illustrated, by
quarter, in Schedule 9.

10. Administrative Expense Budget

The final budget to be developed for operations is the administrative expense budget. Like the
research and development or marketing expense budgets, the administrative expense budget
consists of estimated expenditures for the overall organization and operation of the company.
Most administrative expenses are fixed with respect to sales. They include salaries, depreciation
on the headquarters building and equipment, legal and auditing fees, and so on. The
administrative expense budget is shown in Schedule 10.

11. Budgeted Income Statement

With the completion of the administrative expense schedule, ABT has all the operating budgets
needed to prepare an estimate of operating income. This budgeted income statement is shown in
Schedule 11. The 10 schedules already prepared, along with the budgeted income statement,
define the operating budget for ABT.

Operating income is not equivalent to the net income of a firm. To yield net income, interest
expense and taxes must be subtracted from operating income. The interest expense deduction is
taken from the cash budget. The taxes owed depend on the current tax laws.

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 Cost and Management accounting II

Assignment one Chapter 1

Master Budget for Merchandising Company

YZ Company’s newly hired accountant has persuaded management to prepare a

master budget to aid financial and operating decisions.

The planning horizon is only three months, January to march. Sales in December
(20X3) were Br. 40,000. Monthly sales for the first four months of the next year
(20X4) are forecasted as follows:-

January br. 50,000

February 80,000
March 60,000
April 50,000
Normally 60% of sales are on cash and the remainders are credit sales. All credit Sales
are collected in the month following the sales. Uncollectable accounts are negligent and
are to be ignored.

Because deliveries from suppliers and customer demand are uncertain, at the end of
any month Blue Nile wants to have a basic inventory of Br. 20,000 Plus 80% of the
expected cost of goods to be sold in the following month. The cost of merchandise sold
Averages 70% of sales. The purchases terms available to company are net 30 days.
Each month’s purchases are paid as follows:

50% during the month of purchases and,

50% during the month following the purchase
Monthly expense are:
Wages and Commissions…………………………..Br. 2500+ 15% of sales, paid as incurred
Rent Expenses……………………………………………Br. 2000 paid as incurred
Insurance Expense …………………………………..Br. 200 expiration per month
Depreciation Including truck……………………..br.500 per month
Miscellaneous expenses……………………………5% of sales, paid as incurred
In January, a used truck will be purchased for Br. 3000 cash. The company wants a
minimum cash balance of Br. 10000 at the end of each month. Blue Nile can borrow
cash or repay loans in multiplies of Br. 1000. Management plans to borrow cash more
than necessary and to repay as promptly as possible. Assume that the borrowing takes
place at beginning, and repayment at the ended of the month in question. Interest is
paid when the related loan is repaid. The interest rate is 18% per annum. The closing
Balance sheet for the fiscal year just ended at December 31, 20X3 is:

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 XYZ Company
Balance sheet
December 31,20X3
Assets
Current assets:
Cash Br.10000
Account Receivable 16,000
Merchandise Inventory 48,000
Unexpired Insurance 1800 Br.75,800
Plant Assets:
Equipment, Fixture and Other Br. 37000
Accumulated depreciation 12800 Br. 24,200
Total Asset 100,000

Liabilities and Owners’ equity

Liabilities:

Accounts Payable Br.16, 800

Accrued Wages and commissions Payable 4250 Br.21,050

Capital:

Owners’ equity 78,950

Total liabilities and owners’ equity 100,000.00

Instruction
Using the data given above, prepare the following detailed schedules for the first
quarter of the year:
1. Sales budget
2. Cash collection budget
3. Purchases budget
4. Disbursement for purchases
5. Operating expenses budget
6. Disbursement for operating expenses

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