Cost and Management Accounting - Budgeting and Budgetary Control

 

Cost and Management Accounting

BUDGETING AND BUDGETARY CONTROL

Part A: Discussion of basic theories and definitions including (a) types of budgets, and (b) steps of preparing a budget.

Part B: 10 Illustrations along with solutions

Part A

What is a Budget?

A budget is a quantitative expression of a plan of action relating to the forthcoming budget period. It represents a written operational plan of the management for the budget period. It is always expressed in terms of money or quantity or both money and quantity. It is the policy to be followed during the budget period for attainment of specified organizational objectives and goals.

 

CIMA, London, defines budget as, “Financial and/or quantitative statements, prepared prior to a definite period of time, of the policy to be pursued during that period for the purpose of attaining a given objective.” The basic elements of a budget are:

(i)      It is a future plan of activity for a specified period of time.

(ii)     It is expressed in physical or monetary units or in both.

(iii)    It is prepared in advance, i.e., before the period during which it is to operate.

(iv)   The objectives to be attained and the policy to be pursued to achieve those objectives are required to be laid down before its preparation.

What is Budgetary Control?

Budgetary control is a system with respect to a business organisation involving the use of budgets and budgetary reports throughout the budget period to coordinate and evaluate and control day-to-day operations in accordance with the goals specified by the budget. Budgetary control also involves a constant checking and evaluation of actual results compared with the budgeted activities leading to identifying the corrective measures wherever necessary. CIMA, London, defines budgetary control as, “The establishment of budgets relating the responsibilities of executives to the requirements of a 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.” The process of budgetary control involves the following steps:

a)   Defining and specifying the objectives to be achieved by the business.

b)   Preparing business plans in order to ensure that the desired objectives are accomplished.

c)   Translating the plans into budgets, and relating the responsibilities of individual executives and managers to particular sections of the budget.

d)   Continuous comparison of actual results with the budget, and the calculation of differences between the budgeted and actual performance.

e)   Investigating major differences in order to establish the causes.

f)    Presentation of the information to management in a suitable form, relating the variances to the responsibilities of individual executives and managers.

g)   Corrective actions / measures by the management in order to avoid any wastage or over-expenditure.

h)   Revision of the budget, if necessary, where it is not possible to achieve the budgeted targets due to change in circumstances.

 

Requisites of an effective system of budgetary control

1.  A clearly defined organisational structure, which emphasises areas of responsibility.

2.    Adequate accounting records and procedures, so that performances of the executives and managers can be measured satisfactorily correctly.

3.       Participation by the individuals within the budgeting processes and guidelines.

4.       Awareness of the management of the uses of the budgetary control system.

5.   Awareness of the top management of the problems of budgetary control system, especially of the reactions of the individuals to the budgetary control system.

6.       Flexibility in the budgetary control system, so that plans and objectives may be revised, when it is absolutely required to do so.

 

Steps in Preparing a Budget

Preparing a budget involves the following steps:

1.       Establish budget centres.

2. Prepare a clearly defined organisational chart stating the functional responsibilities of each member of the management team.

3.       Prepare a budget manual.

4.       Form a budget committee.

5.       Determine the limiting or key factor.

6.       Select the budget period.

7.       Set objectives to be reached by the end of the budget period.

8.       Prepare forecasts for the budget period.

9.     Determine enterprise policies (e.g. product range, normal working hours per week, channels of distribution, stock levels, investments in research and development, procurement policies, wages payment methods and incentive schemes, promotional policies, etc.)

10. Compute from the forecasts the requirements in terms of the economic quantities needed to meet the objectives while complying with the policies. This results in initial provisional budgets in terms of quantities.

11.  Convert these quantities into monetary values. This results in initial provisional budgets in terms of values.

12.    Review these initial provisional budgets with respect to the planned objectives and policies, and amend objectives or policies or both repeatedly, if necessary, until the acceptable final budgets emerge.

13.  Formally accept the final functional budgets which then become part of the master budget and as such an executive order.

 

Definitions of some important terms

Budget Centre

A budget centre is a section or department of the organisation identified and separated from the rest of the sections or departments for the purpose of budgetary control. The departmental heads are responsible for fulfilment of all the requirements of the budget policy. Each budget centre should have a separate budget and be subjected to independent comparison with the actuals.

 

Budget Manual

A budget manual is a set of standardized routines and instructions that large organizations follow in budgeting and reporting. Large and complex organizations rely on such a manual to coordinate budgeting activities across several sections or departments of the organisation. Budget manuals are developed and updated through a budget committee that oversees standards and practices within the organisation's financial units.

 

CIMA, London, defines a budget manual as,

“A document, schedule or booklet which sets out inter alia, the responsibilities of the persons engaged in the routine of and the forms and records required for budgetary control”.

 

Budget Committee

In a large concern a budget committee is frequently established. It is a useful device for co-ordinating and reviewing the budget programme. The budget committee should consist of the heads of the various departments and other high-level executives. The budget committee is generally advisory in nature. The principal functions of the budget committee are to:

(i)      Formulate guidelines for the preparation of budgets;

(ii)     Receive and review all budgets;

(iii)    Suggest revisions and amendments;

(iv)   Approve original, revised or amended budgets;

(v)    Recommend action to improve effectiveness;

(vi)   Co-ordinate all activities relating to budgeting.

 

Limiting Factor

A limiting factor is anything that restricts an organisation's ability to maximise its sales due to constraints in demand or the availability of production resources. In each organisation there is always some limiting factor which governs the scale of its activity. A limiting factor is also known as ‘key factor’ or ‘principal budget factor’. Some examples of limiting factors are:

(a)    Production capacity;

(b)    Shortage of space;

(c)     Shortage of skilled labour;

(d)    Shortage of material;

(e)    Low market demand;

(f)      Shortage of capital.

 

The limiting factor is of vital importance when the budget is being prepared. Generally, the two most important limiting factors are market demand for the products and production capacity.

 

Budget Period

A budget period is the period of time for which the budget is prepared and employed. It is necessary at the outset of budget preparation to specify the budget period. Budget periods will vary depending upon the uncertainties involved and the type of business. Long-range budgets are usually concerned with capital expenditure and may span five or more years. Short-term budgets, e.g., the cash budget, may only cover a month. Master budgets which consolidate an organisation’s overall goals are usually prepared on an annual basis mainly to coincide with the financial year of the business. For control purposes it is usual to sub-divide the annual budget into monthly or quarterly budgets.

 

Master Budget

The outcome of the budgeting process will be the collection of a series of subsidiary or functional budgets into a total or master budget. According to CIMA, London, “The master budget is the summary budget incorporating its component functional budgets.”

 

The master budget represents the overall plan of operations developed by management for the company, covering a definite period of time, such as a year. It is a formal expression of managerial policies and goals for a specified period broken down in detail with respect to functions and organisational responsibilities.

 

On completion, the master budget will be submitted to the budget committee together with the subsidiary budgets for approval.

 

Different Functional Budgets

A functional budget is a budget which relates to a major function of the business. The usual functional budgets are:

1.       Sales Budget (in Quantity and Value)

2.       Production Budget (in Quantity)

3.       Production Cost Budget (in Value)

4.       Material Budget (in Quantity and Value)

5.       Purchase Budget (in Quantity and Value)

6.       Labour Budget (in Quantity and Value)

7.       Factory Overhead Budget (in Value)

8.       Office & Administrative Overhead Budget (in Value)

9.       Selling & Distribution Overhead Budget (in Value)

10.    Cash Budget (in Value)

11.    Capital Expenditure Budget (in Value)

12.    Research and Development Budget (in Value)

 

Flexible Budget

A flexible budget is a budget which, by recognizing different cost behaviour / pattern, is designed to take care of the changes in the overall cost structure as volume of output changes.

 

Format for Cash Budget

 

Cash Budget for the period from April to June 2022

Particulars	April	May	June
	Rs	Rs	Rs
Receipts:
Cash Sales
Collection from Debtors
Sale of Assets
Other Receipts
Total (A)
Payments:
Cash Purchase
Payment to Creditors
Wages
Overheads
Purchase of Assets
Taxes
Others
Total (B)
Net Cash Flow (A − B)
Opening Balance
Closing Balance

 

Part B

 

Illustration: 1

From the following figures prepare the raw material purchase budget for January, 2015:

Particulars	Materials
	A	B	C	D	E	F
Estimated stock on Jan 1 (units)	16,000	6,000	24,000	2,000	14,000	28,000
Estimated stock on Jan 31 (units)	20,000	8,000	28,000	4,000	16,000	32,000
Estimated consumption (units)	1,20,000	44,000	1,32,000	36,000	88,000	1,72,000
Standard price p.u.	25 p.	5 p.	15 p.	10 p.	20 p.	30 p.

 

 Solution: 1

Illustration: 2

A company manufactures product - A and product –B. During the year ending 31st December 2015, it is expected to sell 15,000 kg of product A and 75,000 kg of product B at Rs 30 and Rs 16 per kg respectively. The direct materials P, Q and R are mixed in the proportion of 3: 5: 2 in the manufacture of product A, Materials Q and R are mixed in the proportion of 1: 2 in the manufacture of product B. The actual and budgeted inventories for the year are given below:

	Opening Stock	Expected Closing Stock	Anticipated Cost per kg
	(kg)	(kg)	(Rs)
Material – P	4,000	3,000	12
Material – Q	3,000	6,000	10
Material – R	30,000	9,000	8
Product – A	3,000	1,500	-
Product – B	4,000	4,500	-

 

Prepare the Production Budget and Materials Budget showing the expenditure on purchase of materials for the year ending 31-12-2015.

 

Solution: 2

Illustration: 3

The following details apply to an annual budget for a manufacturing company.

Particulars	Quarters
	1st	2nd	3rd	4th
Working days	65	60	55	60
Production (units per working day)	100	110	120	105
% of annual R/M Purchases by weight	30%	50%	20%	-
Budgeted purchase price per kg (Rs)	1	1.05	1.125	-

 

Quantity of raw material required per unit of production is 2 kg. Budgeted closing stock of raw material at the end of the year is 2,000 kg. Budgeted opening stock of raw material at the beginning of the year is 4,000 kg. (Cost Rs 4,000)

Issues are priced on FIFO Basis. Calculate the following budgeted figures.

(a)      Quarterly and annual purchase of raw material by weight and value.

(b)      Closing quarterly stocks by weight and value.

 

Solution: 3

Illustration: 4

Prepare a Selling overhead Budget from the estimates given below:

Particulars	(Rs)
Advertisement	1,000
Salaries of the Sales Department	1,000
Expenses of the Sales Department (Fixed)	750
Salesmen’s remuneration	3,000

 

Salesmen’s Commission: 1% on sales affected

Carriage outwards: estimated @ 5% on sales

Agents’ Commission: 7½% on sales

The sales during the period were estimated as follows:

(a)      Rs 80,000 including Agents’ Sales Rs 8,000

(b)      Rs 90,000 including Agents’ Sales Rs 10,000

(c)      Rs 1,00,000 including Agents’ Sales Rs 10,500

 

Solution: 4

Illustration: 5

ABC Ltd. a newly started company wishes to prepare a Cash Budget for 6 months from January, 2022. Prepare the cash budget from the following estimated revenue and expenses.

Month	Total Sales (Rs)	Materials (Rs)	Wages (Rs)	Overheads
				Production (Rs)	S and D (Rs)
January	20,000	20,000	4,000	3,200	800
February	22,000	14,000	4,400	3,300	900
March	28,000	14,000	4,600	3,400	900
April	36,000	22,000	4,600	3,500	1,000
May	30,000	20,000	4,000	3,200	900
June	40,000	25,000	5,000	3,600	1,200

 

Cash balance on 1st January, 2022 was Rs 10,000. A new machine is to be installed at Rs 20,000 on credit, to be repaid by two equal instalments in March and April. Sales commission @5% on total sales is to be paid within a month following actual sales.

 

Rs 10,000 being the amount of 2nd call may be received in March. Share premium amounting to Rs 2,000 is also to be received along with the 2nd call. Period of credit allowed by suppliers — 2 months; period of credit allowed to customers — 1 month, delay in payment of overheads 1 month, and delay in payment of wages ½ month. Assume cash sales to be 50% of total sales.

 

Solution: 5

Illustration: 6

Prepare a Cash Budget for the three months ending 30th June, 2016 from the information given below:

Month	Sales (Rs)	Materials (Rs)	Wages (Rs)	Overheads (Rs)
February	14,000	9,600	3,000	1,700
March	15,000	9,000	3,000	1,900
April	16,000	9,200	3,200	2,000
May	17,000	10,000	3,600	2,200
June	18,000	10,400	4,000	2,300

 

Credit terms are:

(a)    Sales / debtors: 10% sales are on cash, 50% of the credit sales are collected next month and the balance in the following month.

(b)    Creditors: Materials 2 months.

(c)     Wages: 1/4 month.

(d)    Overheads: 1/2 month.

 

Other relevant information is:

  (i)        Plant and machinery will be installed in February 2016 at a cost of Rs 96,000. The monthly instalment of Rs 2,000 is payable from April onwards.

 (ii)     Dividend @ 5% on preference share capital of Rs 2, 00,000 will be paid on 1st June.

(iii)        Advance to be received for sale of vehicles Rs 9,000 in June.

(iv)   Dividends from investments amounting to Rs 1,000 are expected to be received in June.

(v)        Cash and bank balance on 1st April, 2016 is expected to be Rs 6,000.

 

Solution: 6

Illustration: 7

Draw up a flexible budget for overhead expenses on the basis of the following data and determine the overhead rates at 70%, 80% and 90%:

Plant Capacity: 80% Capacity	(Rs)
A.  Variable Overheads:
Indirect labour	12,000
Stores including spares	4,000
Total (A)	16,000
B.  Semi-Variable Overheads:
Power (30% - Fixed; 70% - Variable)	20,000
Repairs (60% - Fixed; 40% - Variable)	2,000
Total (B)	22,000
C.  Fixed Overheads:
Depreciation	11,000
Insurance	3,000
Salaries	10,000
Total (C)	24,000
Total Overheads (A + B + C)	62,000
Estimated Direct Labour Hours	1,24,000

 

Solution: 7

Illustration: 8

The profit for the year of Push On Ltd. works out to 12.5% of the capital employed and the relevant figures are as under:

	(Rs)
Sales	5,00,000
Direct Materials	2,50,000
Direct Labour	1,00,000
Variable Overheads	40,000
Capital Employed	4,00,000

 

The new sales manager who has joined the company recently estimates for the next year a profit of about 23% on capital employed, provided the volume of sales is increased by 10% and simultaneously there is an increase in selling price of 4% and an overall cost reduction in all the elements of cost by 2%.

 

Find out by computing in detail the cost and profit for next year, whether the proposal of sales manager can be adopted.

 

Solution: 8

Illustration: 9

The monthly budgets for manufacturing expenses of a concern for two levels of activity were as follows:

Capacity	60%	100%
Budgeted production (units)	600	1,000
	(Rs)	(Rs)
Wages	1,200	2,000
Consumable stores	900	1,500
Maintenance	1,100	1,500
Power and fuel	1,600	2,000
Depreciation	4,000	4,000
Insurance	1,000	1,000
Total	9,800	12,000

 

You are required to:

  (i)        Indicate which of the items are fixed, variable and semi-variable stating the reason for such classification in each case;

 (ii)           Prepare a budget for 80% capacity; and

 (iii)          Find the total cost, both fixed and variable per unit of output at 60%, 80% and 100% capacity.

 

Solution: 9

Illustration: 10

X Chemical Ltd. manufacture two products AB and CD by mixing the raw materials in the proportion as shown below:

Raw Material	Product AB	Product CD
A	80%
B	20%
C		50%
D		50%

 

The finished weight of products AB and CD are equal in the weight of ingredients. During the month of June, it is expected that 60 tons of AB and 200 tons of CD will be sold.

Actual and budgeted inventories for the month of June are as follows:

	Actual Inventory On 1st June (Tons)	Budgeted Inventory On 30th June (Tons)
Raw Material A	15	20
Raw Material B	10	40
Raw Material C	200	300
Raw Material D	250	200
Product AB	10	5
Product CD	50	60

 

The purchase price of materials for June is expected to be as follows:

Material	Cost per ton
	(Rs)
A	500
B	400
C	100
D	200

 

All materials will be purchased on 3rd of June.

Prepare:

(a)      The Production Budget for the month of June,

(b)      The Material Requirement budget for the month of June, and

(c)     The Material Purchase Budget indicating the expenditure for material for the month of June.

Solution: 10