Budgeting and Profit

Planning
BUDGETING AND PROFIT
PLANNING

Planning Process

Budget-Definition, Meaning
and Purpose

Preparation/Types of Budgets
 Planning Process
Budgeting is a tool of planning. Planning involves specification of
the basic objectives that the organisation will pursue and the
fundamental policies that will guide it. In operational terms,
it involves four steps:
(1) Objectives
Objectives are broad and long-range desired state or position in future.
(2) Goals
Goals are quantitative targets to be achieved in specified period.
(3) Strategies
Strategies represent specific course of action to achieve goals.
(4) Plans
The final step is the preparation of budgets/profit plans. It converts goals
and strategies into annual operating plans.
 Budget
A budget is defined as a comprehensive and coordinated plan,
expressed in financial terms, for the operations and resources
of an enterprise for some specified period in the future.
The essential elements of a budget are:

(1) Plan
(2) Financial terms
(3) Operations and resources
(4) Specific future period
(5) Comprehensive coverage
(6) Coordination
1. Plan
The first ingredient of a budget is its plan. It includes two aspects which
have a bearing on the operations of an enterprise. One set of factors, which
determine a firm’s future operations are wholly external and beyond its
control. The second set of factors affecting future activities are within the
firm’s control and discretion, that is, they are internal.

2. Operations and Resources

A budget is a mechanism to plan for the firm’s operations and resources.
The operations are reflected in revenues and expenses.
The plan also covers the resources of the firm. The planning of resources
means the planning of the various assets and the sources of capital to
finance these assets. The assets could be fixed assets as well as current
assets.

3. Financial Terms
Budgets are prepared in financial terms, that is, in terms of monetary value
such as the rupee, dollar, and so on. The reason is that the monetary unit is
a common denominator.
4. Specified Future Period
A budget relates to a specified period of time, usually one year.

5. Comprehensiveness
A budget is comprehensive in that all the activities and operations
of an organisation are included in it. It covers the organisation as a
whole and not only some segments. The modus operandi is that
budgets are prepared for each segment/facet/activity/division of an
organisation.

6. Coordination
Budgets are prepared for the different components/
segments/divisions/ facets/activities of an organisation so as to take
care of the situations and problems of each component. The
budgets for each of the components are prepared in harmony with
each another. This is called coordination.
 Budget Purpose
The main objectives of budgeting are:

1. Explicit statement of expectations

2. Communication

3. Coordination,

4. Expectations as a framework for judging performance

 1. Explicit Statement of Expectations
One purpose of budgeting is to state expectations in formal terms so that
most of the underlying assumptions may be identified. A firm has the
basic objective of optimising long-run profit. Its long-range goals
also include survival, consumer satisfaction, employee
welfare, personal power and prestige, and so on.
However, a budget does not lay down a statement of expectations in rigid
terms. A budget should be modified when necessary in the light of
the changes in the factors/assumptions on which the
original estimates were based.

2. Communication  
Another purpose of budgeting is to communicate or inform others of the
goals and methods selected by top management. Since budgeting
deals with fundamental policies and objectives, it is
prepared by top management.
 3. Coordination
 Yet another purpose of budgeting is coordination. The term ‘coordination’
refers to the operation of all departments of an organisation in
such a way that there is no bottleneck or imbalance.
In view of the above, coordination is a major function of budgeting.
Budgets should be drafted in such a way that the operations
of the various departments are related to each other for
the achievement of the overall goal.

4. Expectations as a Framework for Judging Performance  

Finally, a budget establishes expectations as a framework for judging
employee performance.
 TYPES OF BUDGETS
The overall budget is known as the master budget. A
master budget normally consists of three
types of budgets:

(i) Operating
(i) Operating Budgets
Budgets

(ii) Financial
(ii) Financial Budgets
Budgets

(iii) Special
(iii) Special Decision
Decision Budgets
Budgets
 1. Operating Budget
Operating budgets relate to physical activities/
operations such as sales, production,
and so on.

Operating budget has the following components

1) Sales budget,
2) Production budget,
3) Purchase budget,
4) Direct labour budget,
5) Manufacturing expenses budget, and
6) Administrative and selling expenses budget, and
so on.
 2. Financial Budget
Financial budgets are concerned with expected
cash flows, financial position and
result of operations.

Financial budget has the following components

1) Budgeted income statement,
2) Budgeted statement of retained earnings,
3) Cash budget, and
4) Budgeted balance sheet.
 Cash Budget
Cash budget is a device to help a firm to plan for and control the use of
cash. It is a statement showing the estimated cash inflows and cash
outflows over the planning period. The principal aim of the cash
budget, as a tool to predict cash flows over a period of time,
is to ascertain whether there is likely to be excess/shortage of cash at any
time.

The preparation of a cash budget involves several steps.

The first element of a cash budget is the selection of the period of
the budget, that is, the planning horizon.
The second element of the cash budget is the selection/identification
of the factors that have a bearing on cash flows.
The factors that generate cash are generally divided into two broad
categories:
(i) Operating (ii) Financial
 Operating Cash Flow
The main operating factors/items which generate cash
outlfows and inflows over the time span of a
cash budget are tabulated in Exhibit 1.
Exhibit 1.  Operating Cash Flow Items
Cash inflows/Receipts Cash outflows/Disbursements
1.Cash sales 1. Accounts payable/Payable payments
2.Collection of accounts 2. Purchase of raw materials
receivable 3. Wages and salary (pay roll)
3.Disposal of fixed assets 4. Factory expenses
5. Administrative and selling expenses
6. Maintenance expenses
7. Purchase of fixed assets
 Financial Cash Flow Items
The major financial factors/items affecting generation
of cash flows are depicted in Exhibit 2.
Exhibit 2.  Financial Cash Flow Items
Cash inflows/Receipts Cash outflows/Payments
1. Loans/borrowings 1. Income tax/tax payments
2. Sale of securities 2. Redemption of loan
3. Interest received 3. Re-purchase of shares
4. Dividend received 4. Interest paid
5. Rent received 5. Dividends paid
6. Refund of tax
7. Issues of new shares and securities
Example 1  
The following data relate to Hypothetical Limited:
Balance Sheet as at March 31, Current Year
Liabilities Amount Assets Amount
Accounts payable Cash Rs 3,00,000
  (all for March purchases) Rs 40,000 Accounts receivable
Taxes payable   (all from March sales) 2,50,000
  (all for March income) 25,000 Inventories:
Share capital 11,00,000   Raw materials (9,600 kgs ×Rs 3) 28,800
Retained earnings 10,26,800   Finished goods
    (1,800 units ×Rs 35)
Fixed assets: 63,000
  Cost Rs 20,00,000
  Less: Accumulated
_______         depreciation (4,50,000) 15,50,000
21,91,800 21,91,800
2. Sales forecasts: Assume the marketing department has developed the
following sales forecast for the first quarter of the next year and the selling
price of Rs 50 per unit.
Month Units sales
 April 9,000
 May 12,000
 June 16,000
3. The management desires closing inventory to equal 20 per cent of the
following month’s sales.
4. The manufacturing costs are as follows
Direct materials: (5 kgs ×Rs 3) (per unit) Rs 15
Direct labour 5
Variable overheads 9
Total fixed overheads (per annum)
7,20,000
5. Normal capacity is 1,20,000 units per annum. Assume absorption costing
basis.
6. Each unit of final product requires 5 kgs of raw materials. Assume
management desires closing raw material inventory to equal 20 per cent
of the following month’s requirements of production.
7. Assume fixed selling and administrative expenses are Rs 20,000 per
month and variable selling and administrative expenses are Rs 5 per
unit sold.
8. All sales are on account. Payment received within 10 days from the date
of sale are subject to a 2 per cent cash discount. In the past, 60 per cent
of the sales were collected during the month of sale and 40 per cent are
collected during the following month. Of collections during the month of
sale, 50 per cent are collected during the discount period. Accounts
receivable are recorded at the gross amount and cash discounts are
treated as a reduction in arriving at net sales during the month they are
taken.
9. Tax rate is 35 per cent.
10. Additional information:
(a) All purchases are on account. Two-thirds are paid for in the month
of purchase and one-third, in the following month.
(b) Fixed manufacturing costs include depreciation of Rs 20,000 per
month.
(c) Taxes are paid in the following month.
(d) All other costs and/or expenses are paid during the month in which
incurred.
From the foregoing information prepare a master budget for the month of
April only.
Solution
1.Production Budget
Particulars April  May 
Sales (units) 9,000 12,000
Add: Desired closing inventory (0.20 ×next month’s sales) 2,400 3,200
Total finished goods requirement 11,400 15,200
Less: Opening inventory (1,800) (2,400)
Required production (units) 9,600 12,800
2.Manufacturing Cost Budget
 Particulars April 
Required production (units) 9,600
Direct material cost (5 kgs ×Rs 3 per kg) ×Rs 15
Total direct material cost Rs 1,44,000
Total direct labour cost (Rs 5 per unit) 48,000
Total variable overhead cost (Rs 9 per unit) 86,400
Total variable manufacturing costs 2,78,400
All fixed manufacturing overheads (Rs 7,20,000 ÷ 12 months) 60,000
Total manufacturing cost 3,38,400
3.Purchase Budget (Raw Materials)
Particulars April  May 
Production requirement (units) 9,600 12,800
Raw material required for production @ 5 kgs per unit ______ _____
(kgs) 48,000 64,000
Add: Desired closing inventory (0.20 ×May
requirements) 12,800
Total requirements 60,800
Less: Opening inventory (9,600)
Purchase requirement 51,200
Purchase requirement (amount @ Rs 3 per kg) Rs 1,53,600
4.Selling and Administrative Expenses Budget
 Particulars April 
Units sales 9,000
Variable costs @ Rs 5 per unit Rs 45,000
Fixed costs 20,000
Total selling and administrative expenses 65,000
5. Cost of Goods Sold Budget
 Particulars April 
Units sold 9,000
Cost per unit
Variable Rs 29
Fixed (Rs 60,000 ÷ 10,000 units) 6 ×Rs 35
Total cost 3,15,000
6. Budgeted Income Statement for the Month of April
Gross sales (9,000 ×Rs 50) Rs 4,50,000
Less: Cash discount (Rs 4,50,000 ×0.6 ×0.5 ×0.02) 2,700
Net sales 4,47,300
Less: Cost of goods sold 3,15,000
Gross margin (unadjusted) 1,32,300
Less: Capacity variance unfavourable (400 units ×Rs 6) 2,400
Gross margin (adjusted) 1,29,900
Less: Selling and administrative expenses 65,000
Earnings before taxes 64,900
Less: Taxes (0.35) 22,715
Earning after taxes 42,185
7.Budgeted Statement of Retained Earnings
Opening balance Rs 10,26,800
Add: Earnings after taxes 42,185
Closing balance 10,68,985
8.Cash Budget (April)
Opening balance Rs 3,00,000
Cash inflows:
 Collection from debtors:
March sales Rs 2,50,000
April sales (gross) (Rs 4,50,000 ×
0.60)
Rs 2,70,000
Less: Cash discount
  (Rs 2,70,000 ×0.5 ×0.02) 5,17,300
2,700 2,67,300 Rs 8,17,300
Cash outflows:
 Payment to creditors:
  For March purchases
40,000
  For April purchases (Rs 1,53,600
×2/3) 1,42,400
Direct labour 1,02,400
48,000
Variable manufacturing overhead 86,400
Fixed manufacturing overhead
Less: Depreciation 60,000
(20,000) 40,000
Variable selling and administrative 45,000
overheads
Fixed selling and administrative
overheads 20,000
Taxes 25,000 4,06,800
Closing balance 4,10,500
9. Proforma Balance Sheet as at March 31, Next Year
Liabilities Amount Assets Amount
Accounts payable Cash Rs 4,10,500
   (Rs 40,000 + Accounts receivable
Rs 1,53,600  –   (Rs 4,50,000 ×0.40) 1,80,000
Rs 1,42,400) Rs 51,200 Inventories:
Taxes payable   Raw material
(Rs 25,000  + Rs 22,715   (12,800 ×Rs 3) Rs 38,400
– Rs 25,000) 22,715   Finished goods
Share capital 11,00,000   (2,400 ×Rs 35) 84,000 1,22,400
Retained earnings 10,68,985 Fixed assets:
  Cost 20,00,000
  Less: Accumulated
________     depreciation (4,70,000) 15,30,000
22,42,900 22,42,900
 Special Decision Budgets
The third category of budgets are special decision
budgets. They relate to inventory levels, break-even
analysis, and so on.

Fixed and Flexible Budgets

Fixed Budgets
Budgets prepared at a single level of activity, with no prospect of
modification in the light of changed circumstances, are referred to
as fixed budgets.
Flexible Budgets
The alternative to fixed budgets are flexible/variable/sliding
budgets
 Flexible Budgets
The term ‘flexible’ is an apt description of the essential
features of these budgets. A flexible budget estimates costs
at several levels of activity.

Its merit is that instead of one estimate, it contains several

estimates/plans in different assumed circumstances. It
is a useful tool in real world situations, that is, unpredictable
environment.

A flexible budget, in a sense, is a series of fixed budgets and

any increase/decrease in the level/volume of activity must be
reflected in it.
The conceptual framework of flexible budgeting relates
to: (i) Measure of volume and (ii) Cost behaviour with
change in volume

Each expense in each department/segment is to be

categorised into fixed, variable and mixed components.
A budget may first be prepared at the expected level of
activity, say, 100 per cent capacity. Additional
columns may then be added for costs below and above,
90 per cent and 110 per cent capacity and so on.
Table 1  Hypothetical Ltd—Flexible Budget (Maintenance Department)
Volume (labour-hours) 4,000 4,500 5,000 5,500 6,000
Variable costs:
Labour Rs 6,000 Rs 6,750 Rs 7,500 Rs 8,250 Rs 9,000
Material 2,400 2,700 3,000 3,300 3,600
Others 800 900 1,000 1,100 1,200
Mixed costs:
Labour 2,300 2,400 2,500 2,600 2,700
Maintenance 1,400 1,450 1,500 1,550 1,600
Other supplies 2,500 2,750 3,000 3,250 3,500
Discretionary fixed costs:
Training 1,500 2,000 2,000 2,000 2,500
Experimental methods 3,500 4,000 4,000 4,000 4,500
Committed fixed costs:
Depreciation 5,000 5,000 5,000 5,000 5,000
Rent, lease cost 3,500 3,500 3,500 3,500 3,500
Total 28,900 31,450 33,000 34,550 37,100
Table 2: Hypothetical Ltd—Flexible Budget (Manufacturing Department)
Volume (machine-hours) 50 60 70 80 90
Variable costs:
Power Rs 500 Rs 600 Rs 700 Rs 800 Rs 900

Helpers 250 300 350 400 450

Discretionary fixed costs:

Training 800 900 900 900 1,000

Tools 200 200 200 300 300

Committed fixed costs:

Depreciation 1,200 1,200 1,200 1,200 1,200

Rent 1,000 1,000 1,000 1,000 1,000

Total 3,950 4,200 4,350 4,600 4,850