FINANCIAL AND MANAGERIAL

ACCOUNTING
MBA 2014

TOPIC 8: Budgetary planning and control

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 Contents
1. Introduction
2. Functions of a budget
3. Budgetary Process
4. Methods of preparing budgets
5. Types of budgets (Production, Income
statement and cash)
6. Budgetary control - Variance analysis
7. Benefits and limitations of budgets

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 1. Introduction
A budget is a plan of action that is expressed
in financial terms or is a plan that has been
quantified. A budget and the budgeting
process is normally one of the steps or
stages in the planning process of an
organization.
A budget serves several functions which are
discussed next.
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 2. Functions of a budget
1. Planning annual operations. To enable
the managers anticipate problems, make
the correct decisions and minimize any
problems that may arise in the future.
2. Coordination of the activities of the
various departments so that they can
work in harmony to achieve the overall
organization goals.
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 2. Functions of a budget
3. Communication; A budget serves the role of
informing all the departments and employees of
what needs to be done and how this will be done
and what objectives will be met.
4. It can also be a motivator i.e. it can influence the
performance level of employees and the
management, this is because the budget will set
the standards for which the employees strive to
achieve.

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 2. Functions of a budget
5. It is an important tool of control because the
budgeting process enables the management to
operate a system of management by exception
(MBE) i.e. the manager’s attention is
concentrated on deviations from the expected
results.
6. Performance evaluation. Whereby a manager can
be assessed based on whether he or she is able
to meet the expected budget levels.

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 3. Budgetary process
In preparing the budget, it is important to have a general process
so that the budget is successful. The process will depend on
the nature of the organization but it should have the following
stages:

1. Communicate the details of the budget policies and guidelines to those

who are responsible for preparing of the budget .
2. Determining the factors that restrict output e.g. low demand, or scarcity in
resources such as materials labor and capacity.
3. Prepare the revenue budget. This establishes the revenues (total incomes
from selling goods or providing services and/or donations) so that costs
musts not exceed the revenues.

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 3. Budgetary process
4. Initial preparation of the various budgets. I.e. A manager is
expected to prepare a budget for the areas for which he/she is
responsible.
5. Negotiation of the budgets with supervisors.
6. Coordination and review of the budgets the whole stage is
coordinated and any inconsistencies identified, at this stage a
master budget that includes a budgeted income statement and a
statement of financial position.
7. Final acceptance of the budget and approval of the budget.
8. Budget review, this is the periodical comparison of the actual and
the expected budgeted results.

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 4. Methods of preparing budgets
There are several types of budgets that can be
prepared and also several methods/tools
than can be used to prepare budgets. Before
we look at the different types of budgets we
can look at various approaches, methods
and tools that are used in preparing budgets.
These are discussed next.

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 4. Methods of preparing budgets
1) Incremental Budgeting
It is also referred to as traditional budgeting and it involves the
use of previous period’s budget/actuals as a baseline for
preparing the current period’s budget.
The current period’s budget is thereafter determined by adding
or subtracting amounts from the previous budget in line with
actual events for the last period and any new assumptions to
be made in the current period, the main advantage of this
method is that it is very quick and easy to use but
unfortunately it may carry forward previous period’s
inefficiencies.

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 4. Methods of preparing budgets
2. Zero based Budgeting
This method of budgeting has been
developed because of the limitations of
incremental budgeting. In preparing the
current period’s budget, the starting
point is to assume that there is no
expenditure at all i.e. there is zero
expenditure.
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 4. Methods of preparing budgets
Thereafter, any expenditure to be included in
the budget must be justified. This means that
each and every activity will be scrutinized in
detail before any amounts can be spent at all.
Activities will thereafter be ranked in order of
priority i.e. what is essential, resources will
only be allocated to the essential activities.

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 4. Methods of preparing budgets
3. Activity Based Budgeting.
This is a budgeting method that requires
the use of activities (production times,
deliveries etc) rather than use of
production or sales levels. It is a method
of improving activity based costing where
by the organization can identify new and
priority activities.
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 4. Methods of preparing budgets
The firm will concentrate on efficiency
and effectiveness and avoid the
arbitrary allocation of costs. However,
due to the limited availability of
information and the complexity
involved activity based budgeting may
be difficult to achieve.
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 4. Methods of preparing budgets
4.Rolling Budget
It is a budget kept continually up to date. It
involves splitting the main budget or the
annual budget into several periods e.g. month
by month or quarterly and thereafter updating
the periodical budget with the previous actual
results e.g. the budget for February can be
adjusted with the actual transaction that took
place in the month of January.

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 4. Methods of preparing budgets
This is normally used where the initial estimates are
unreliable or it is the first period of operations and to
improve on periodical planning and controlling. The
main limitations is that it is an extension of
incremental budgeting and therefore inefficiencies
will keep on being carried forward. Furthermore,
rolling budgets tend to change the targets and
therefore it becomes difficult to evaluate the
performance of the management.

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 4. Methods of preparing budgets
5. Flexible Budget.
This is a budget that is prepared based on
different levels of activities. It is a budgeting
system that considers the outcomes of the
period given different levels of activity. Its
basis is on the different cost behavior patterns
and therefore the expenses of the business
will have to be classified into variable and
fixed.

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 4. Methods of preparing budgets
It is an important control tool that aids in decision
making and helps the management identify potential
problems and evaluate performance. However
flexible budgets may require a lot of assumptions in
their preparation and careful analysis of cost into the
variable and fixed components. Flexible budgets are
alternative to fixed budgets. Fixed budgets are only
prepared based on the main anticipated level of
activity, no adjustments are made for any changes in
the level of activity.

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 5. Types of budgets
1. Revenue. (A forecast of total revenue)
For firms that sell goods (e.g. pharmaceutical
co.s), sales/revenue budget shows the
quantities of each product to be sold and the
intended selling price hence total sales. It
provides the foundations of all other
budgets.
Total Revenue = Expected units to be sold x
Selling price.
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 5. Types of budgets
For firms that provide a service, revenue budget
shows the total incomes that would be
received from providing the service. For
example in a hospital, this could be in form of
the various amounts patients will pay for a
service i.e. consultancy fees, medical
examination and donations. Sale of medicine
can be treated as revenue here too.

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 5. Types of budgets
2. Production and inventory level budgets
(Units to be produced and inventory levels)
The production budget is expressed in terms of
quantities only and the objective is to ensure
that production is sufficient to meet the sales
demand and economic inventory levels are
maintained.
Production level in units = Closing inventory +
Sales – Opening inventory.
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 5. Types of budgets
3. Direct materials usage budgets (Total costs of
materials that will be consumed).

This shows how much materials are required to

meet the production budget.
Total Production(units) x Quantity of material
per unit x Purchases price per unit of material

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 5. Types of budgets
4. Direct Material Purchase Budget.
Once the material usage budget is prepared it is
important to determine how much material
should be purchased so as to meet production
requirements.
= (closing materials + materials usage – opening
materials) x Purchase price per unit of
materials

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 5. Types of budgets
5. Direct labour budget (How much will be
spent on labour costs in prdn).

This is the expected total expenditure on labour

to meet the production levels
= Production in units x hours per unit x rate per
unit

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 5. Types of budgets
6. Production overheads budget (Variable and
fixed production overheads budget)
In most cases the fixed overhead expenditure
may be given as a flat figure or amount while
the variable may be determined by
multiplying the overhead with either the total
production in units or the labour hours.

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 5. Types of budgets
7. Non production overheads budget (Selling,
administration and distribution overheads)
This is also given by getting the total
expenditure for the various selling,
administration and distribution expenses. It is
determined by adding up all expenses under
this category such as salaries, commission,
advertising and others.

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 5. Types of budgets
8. Cash budget ( Forecast receipts and
payments and cash balance).
9. Income statement and statement of financial
position (Forecast income statement and
statement of financial position).
Budgets are normally done on an annual basis
i.e. covering one financial period but they can
also be analyzed into months or quarters.

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 6. Variance analysis
Variance analysis is a control technique in which
a comparison is made between the budgeted
results costs and revenues with the actual
results. A variance is the difference between
actual and expected result, when the actual
results are better than expected then we have
favorable variance, and if the actual results
are worse than expected then we have an
adverse or unfavorable variance.
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 6. Variance analysis
In order to carry out variance analysis, the
organization should establish standard costs
and standard selling prices of its units and
services. In this case a standard is a pre
determined measurable quantity that is set in
defined conditions and is expressed in
monetary terms. The standard costs and
prices are then used in budgeting.

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 6. Variance analysis
Variance analysis is normally carried out more
specifically for income statement items i.e. to
know why the actual profit is different from
budgeted profit.
Variances are therefore classified into three
main categories:
1. Production costs variances
2. Non Production cost variances
3. Sales variances
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 1. Variance analysis
1. Production cost variance
(a) Direct Material cost variance
(Standard cost – Actual cost)
Price = (Actual Price – Standard Price x Actual
Quantity Purchased)
Usage = (Actual Quantity Used – Standard
Quantity Used) x Standard Material price

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 1. Variance analysis
(b) Direct Labor cost variance
(Standard cost – Actual cost)
Rate = (Actual rate – Standard rate x Actual
hours worked)
Efficiency = (Actual hrs worked – Standard
hrs) x Standard Labor rate
Idle time variance = Idle time hours x
Standard rate

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 1. Variance analysis
(c) Variable production overheads variance
(Actual Cost – Standard Cost)
Expenditure = (Actual variable overhead rate –
Standard variable overhead rate) x Actual
hours.
Efficiency = (Actual hours – Standard hours) x
Standard variable overhead rate.

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 1. Variance analysis
(d) Fixed production overheads variance
(Actual Cost – Absorbed)
Expenditure = Actual Fixed Production
overhead – Budgeted fixed production
overheads.
Volume = (Actual Qty produced - Budget Qty)
x Fixed Production cost per unit.

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 1. Variance analysis
Fixed production volume variance can also be
analyzed into capacity and efficiency.

Capacity = (Actual hrs – Budgeted hours)x

Standard fixed overhead Production rate (SFOR)
Efficiency = (Actual Hrs – Standard hours) x
Standard fixed overhead Production rate
(SFOR)

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 1. Variance analysis
(2) Non production costs variance

This is normally the difference between actual

and budgeted expenditure for Selling and
distribution and administration overheads

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 1. Variance analysis
(3) Sales variances
Sales variance can be used to analyze the
performance of the sales function and is
normally extended to analyze the impact on
the budgeted profit.
The two main categories are:
– Selling price variance.
– Sales volume profit variance.

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 1. Variance analysis
Selling Price Variance = (Actual Price – Standard
price) x Actual Quantity sold.
Sales Volume profit variance =
(Budgeted Quantity sold – Actual Quantity
sold) x Standard Profit

REFER TO ADDITIONAL NOTES ON THE CAUSES

OF THE VARIOUS VARIANCES

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 1. Variance analysis
Operating statement
An operating statement is normally prepared to
reconcile the actual profit and the standard or
budgeted profit. Both the standard profit and
the budgeted profit will be computed before
the non production expense. However, this
statement may also be extended to indicate
the non production variances.

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 7. Benefits and Limitations
Benefits of Budgeting.
1.Budgeting helps the management achieve their responsibility
of planning and controlling the business.
2. It also assists the management to be able to think strategically,
anticipate and respond to changes in the operating
environment.
3. It improves production efficiency, reduces wastes and controls
cost.
4. It also assists the firm to maximize its revenues and profits
especially by controlling the costs.

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 7. Benefits and Limitations
Benefits of Budgeting.
5. It provides a basis on which the performance of the
management can be evaluated.
6. It helps in allocating scarce resources to the most
important activities.
7. It motivates the management and employees to
attain some goals.
8. It assists in delegation of authority by ensuring that
someone is responsible for certain costs.

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 7. Benefits and Limitations
Limitation of Budgeting.
1.Budgets are based on historical data which may not
be an accurate indicator of the future.
2. Budgets are also based on estimates that depends on
accuracy of the tools used in estimation.
3. There is danger of rigidity, this is because the
management will only be interested in achieving the
given set of goals and they may not adopt and try to
be flexible and innovative to changing business
environment.

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 7. Benefits and Limitations
Limitation of Budgeting.
4. In most cases a budgeting system is very expensive
because it requires time and a lot of resources to
implement the system.
5. A budgeting system also relies on the goodwill of the
management and employees. Therefore the
employees must be involved in the process
otherwise they may frustrate the budgeted process
by either not supporting it or coming up with
unreasonable estimates.

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 8. Success factors
1. Involve all relevant stakeholders (Probably a
bottom up approach)
2. Provide employees with all possible resources
and time
3. Transparency and prompt communication
4. Identify all behavioral issues that may affect
employees and management (Slack)
5. There has to be a good system of collecting
and reporting reliable data.
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