CERTIFICATE LEVEL

Subject Fundamentals of Management Accounting (BA2)

K.Sivagar
Lecturer B.Sc (Hons), ACMA, CGMA

Module Tute 08 – Budgeting

Code BA2/KS/08
 Budgeting

Budget
Budget is a quantified plan of action relating to a given period of time. The time period for which budget
is prepared is known as budget period. Generally, it is one year due to the reason that financial report for
most of the organizations cover one-year periods. But the budget can be for any length of time that suits
the business and its management.

The purposes of budgeting

1. Planning
2. Control
3. Co-ordination
4. Communication
5. Motivation
6. Performance evaluation
7. Authorization

Levels of budgeting
There are three levels of planning and decision making that need to take place in a business for it to
operate as its full potential. The three levels are,

1. Strategic
2. Budgetary
3. Operational

Strategic Planning

It is concerned with preparing long term actions plans to attain the organization’s objectives. Strategic
decisions deal with the big picture of the business.

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Budgetary Planning

Budgetary planning is concerned with preparing short to medium term plans of the organization. These
budgetary plans, which are known also as tactical plans should be within the framework of strategic plan.
An entity’s budget can be seen as a step towards achieving the long-term plan. (Strategic plan)

Operational Planning

Operational planning is concerned with the day-to-day planning process. The decisions about how the
entity’s resources will be utilized to achieve the budgetary plans will be taken.

Budgetary Planning and Control

Budgetary planning and preparation will make sure that the organization has started out in the right
direction. But to ensure that it continues on course, good control system should be exercised. Each budget
period is normally split into control periods known as budget intervals. It is generally 3 months or 1 month
at the end of each budget interval, the actual result will be compared with budget and appropriate action
can be taken to correct any deviations from the plan. Budget was defined as “Quantified plan” to ensure
that the budget targets can be compared against measured actual performance.

The Preparation of Budgets

The Budget Committee
The budget is interrelated. That is one budget cannot be completed without reference to several other
budgets. Therefore, it is critical to coordinate the budget planning process which is best achieved by
setting up a budget committee. It should comprise of representatives from all the functional areas of the
organization.

The budget committee will be responsible for the preparation of all the budgets. Regular meetings of
budget committee will be held in order to review the budget planning process and to resolve any problem
that has arisen.

The Budget Manual

Budget manual is a collection of key information that are needed for the budget preparation. The
provision of adequate information will make the budgeting process more effective. Typical contents of a
budget manual can include the following.

• An explanation about the budgeting process.

• Organization chart.
• Timetable and deadlines for the preparation of each budget.
• List of organization’s accounting codes.

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• Key assumptions to be made.
• The name and contact details of the person to be contacted regarding any problems encountered in
budgeting.

Principal Budget Factor

Principal budget factor is the factor which limits the activities of the organization during the budget period.
Principal budget factor should be identified at the early stages of budget planning process because the
order of preparing the budgets will be decided based on it.

Eg: - sales volume.

All other budgets should then be linked to this.

Interrelationship of Budgets

The critical importance of the principal budget factor stems from the fact that all budgets are interrelated.
If sale is the principal budget factor this is the first budget to be prepared. This will then provide the basis
for the preparation of several other budgets, and all the budgets are interrelated with each other.

Using Spreadsheets in Budget Preparation

Due to interrelationship between budgets spreadsheets are useful in budget preparation, because
changes in one budget can have a knock-on effect on several other budgets.

Operational Budgets (Functional Budgets)

SALES BUDGET

Product A Product B
Sales quantity (units) XXX XXX
Selling price / unit ($) X X
Sales ($) XXX XXX

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PRODUCTION BUDGET

Product A Product B
Sales quantity (units) XXX XXX
Add: closing stock – FG (units) XXX XXX
Less: opening stock – FG (units) (XXX) (XXX)
Production quantity (units) XXX XXX

MATERIAL USAGE BUDGET

Production quantity Material X Material Y Material Z

Product (A) (units) XXX XXX XXX
Per unit material X X X
requirement
( KG , L, M, etc )
Material usage XXX XXX XXX
( KG , L, M, etc )
Product (B) (units) XXX XXX XXX
Per unit material X X X
requirement
( KG , L, M, etc )
Material usage XXX XXX XXX
( KG , L, M, etc )
PURCHASE BUDGET

Material X Material Y Material Z

Material usage XXX XXX XXX
( KG , L, M, etc )
Add: closing stock (RM) XXX XXX XXX
Less: opening stock (RM) (XXX) (XXX) (XXX)
Purchase XXX XXX XXX
( KG , L, M, etc )

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PURCHASE BUDGET

Material X Material Y Material Z

Purchase XXX XXX XXX
( KG , L, M, etc )
PRICE / ( KG , L, M, etc ) X X X
Purchase($) XXX XXX XXX

LABOUR BUDGET

Product A Product B
Production units (production XXX XXX
budget)
Labour hours per unit X X
Total labour hours XXX XXX
Rate per hour X X

Labour cost ($) XXX XXX

OVERHEAD BUDGET

Product A Product B
Production units XXX XXX
Variable overhead (£) XXX XXX
(production units x VOH/unit)
Fixed production overhead (£) XXX XXX
(production units x FPOH/unit)

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 Budget preparation

SALES BUDGET
Step 1

Step 2 PRODUCTION BUDGET

RAW MATERIALS LABOUR FACTORY OVERHEAD

Step 3

COST OF GOODS SOLD

BUDGET

SELLING & GENERAL &

DISTRIBUTION ADMINISTRATION
EXPENSES BUDGET EXPENSES BUDGET
Step 4 BBUDGET

MASTER BUDGET
BUDGETED
Step 5 STATEMENT OF P/L

Step 6 CAPITAL EXPENDITURE

CASH BUDGET BUDGET

BUDGETED STATEMENT
Step 7 OF FINANCIAL POSITION

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 Master Budget

It is a summary of all the functional budgets. This is prepared to submit to the senior managers to get the
approval for budgets. The following items must be included in a master budget.

1. Budgeted statement of profit or loss

2. Budgeted statement of financial position
3. Cash budget

Practice Question – 01

A company manufacturing two products, Aye and Bee standard cost data for the products for next year
is as follows:

Direct materials Product aye Product bee

Per unit Per unit
X at £ 2per kg 24kg 30kg
Y at £ 5per kg 10kg 8kg
Z at £ 6per kg 5kg 10kg

Direct labour

Unskilled at £3 per hour 10 hours 5 hours

Skilled at £ 5 per hour 6 hours 5 hours

Budgeted stock for next year is as follows,

Product Aye product Bee

Units units
1st January 400 800
31st December 500 1,100

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 Material X Material Y Material Z
Kg kg kg
1st January 30,000 25,000 12,000
31st December 35,000 27,000 12,500

Budgeted sales for next year:

Product Aye 2,400 units
Product Bee 3,200 units

Prepare the following budgets for next year:

a) Production budget, in units
b) Material usage budget in kgs
c) Material purchases budget, in kg and by value
d) Direct labour budget, in hours and by value

Cash Budget

Liquidity management is very critical for a company. Cash budget will forecast the liquidity position of the
company for the budget period.

Cash budget is detailed budget of cash inflows and outflows which will show the forecasted cash balance
at the end of the budget period. Based on this any potential problems can be identified, and proper actions
can be planned.

There are four possible cash positions that could arise.

Cash Position Possible Solutions

Short- term deficit Arrange bank overdraft

Reduce debtors and stocks
Increase creditors
Post pone capital expenditures if possible
Long- term deficit Raise long- term finance such as share capital or
long- term loans

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 Short- term surplus Short-term investments
Increase debtors and stock
Pay creditors early and obtain cash discounts.
Long- term surplus Expand or diversity operations
Replace fixed assets if necessary
Replace long term loans

Preparing cash budget

Month 1 Month 2
Receipts XXX XXX

Less: payment (XXX) (XXX)

Net receipts XXX XXX

Balance brought forward XXX XXX

Balance carried forward XXX XXX

Notes:-

1. Depreciation is not included in cash budget.

2. Allowance must be made for bad and doubtful debts.

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Practice Question – 02

Watson Ltd is preparing its budgets for the next quarter. The following information has been drawn
from the budgets prepared in the planning exercise so far.

Sales value June (estimate) $12,500

July (budget) $13,600
August $17,000
September $16,800

Direct wage $1,300 per month

Direct material purchases June (estimate) $3,450

July (budget) $3,780
August $2,890
September $3,150

• Watson sells 10% of its goods for cash. The remainder of customers receives 1 month’s credit. No
bad debts are anticipated.

• Payments to creditors are made in the month following purchase.

• Wages are paid as they are incurred.

• Watson takes 1 month’s credit on all overheads

• Production overheads are £ 3,200 per month

• Selling, distribution and administration overheads amount to £ 1890 per month.

• Included in the amounts for overhead given above are depreciation charge of £300 and £190,
respectively.

• Watson expected to purchase a delivery vehicle in august for a cash payment of £ 9,870.

• The cash balance at the end of June is forecast to be £ 1,235.

Prepare a cash budget for cash of the months from July to September.

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Approaches to budgeting
• Rolling and periodic budgets
• Incremental and zero-based budgeting
• Participative and imposed budgeting

Rolling budget

A budget that is continuously updated based on available current information. At the end of a sub period
of budget one period will be removed and a new period will be added.

Periodic budget

A periodic budget shows the costs and revenue for one period of time, e.g. a year and is updated on a
periodic basis. E.g. every 12 months.

Incremental budget

The budget that is prepared by adding an allowance to the last period actual is incremental budget. This
is a weak budget since it allows current period inefficiency to the future period.

Zero based budget

A budget that is prepared assuming the past is zero. Budgets are prepared with the assumption of
activity is undertaken first time.

Top – down budgeting (Imposed budgeting)

Budgets are prepared by the top management and imposed on the lower layers of the organization.

Budget will clearly express the performance goals and the expectations of top management. In this
method the ultimate budget holders are not given the opportunity to participate in the budgeting
process.

Bottom – up budgeting (participative budgeting)

It is a budgeting system in which all budget holders are given the opportunity to participate in setting
their own budgets.

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 Advantages:-

o Improved quality of forecasts to use as the basis for the budget

o Improved motivation

Disadvantages:-

o Budget padding
Managers may negotiate budgets which are easy to achieve by over stating the costs
and understating the revenue targets. The intentional under/over estimation figures
are known as budget slack

o The budget process will be complex

Budget centers

A section of an entity for which control may be exercised through prepared budgets. Each budget center
will have its own budget and a manager will be responsible for managing the centre and controlling the
budget. This manager is often referred to as the budget holder. Costs attributed to individual budget
centers may be classified as controllable or non-controllable.

Budgetary control report

A report prepared highlighting the important items of the variances where possible reasons are identified
is known “Budgetary control report”. Such reports should contain the following characteristics.
1. Timely
2. Accurate
3. Relevant to the recipient
4. Communication to the correct manager.

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 Flexible budgets

During the budget control period, a commonly identified problem is that the actual activity level may be
different from the budgeted activity level. In that case, the actual results cannot be compared with budget
for control purposes.

The problem is dealt with by preparing flexible budget. All the possible activity levels will be identified in
advance; budget will be prepared for all those activity levels. When we need compare with actual results,
appropriate budget will be considered.

The original budget is known as fixed budget and the budgets for different activities are known as flexed
budgets. When we flex the budgets, an appropriate technique we can use is called “high-low” (high and
low means the activity levels)

Where,

• Variable costs vary in proportion to the activity level

• Fixed cost remains constant independent of the activity level

Practice Question - 03
Sales / production (units) 4,000 6,000
Material cost 40,000 60,000
Labour cost 80,000 120,000
Production overhead 90,000 110,000
Administration overhead 108,000 112,000
Selling & distribution overhead 92,000 108,000

Prepare flexible budget at 8750 units, 9480 units and 11200 units.
The total budget variance

Total budget variance is the difference between the fixed budget and actual results. Total budget
variance comprised of two sub variances.

1. Expenditure variance
2. Volume variance

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Ex:-

Fixed budget Flexible budget Actual budget

£ £ £
Direct material 19,200 16,000 16,450
Direct labour 13,200 12,400 12,380
Production overhead 24,000 23,000 24,120
Administration overhead 21,000 21,000 21,600
Selling & distribution overhead 16,400 16,000 16,200
93,800 88,400 90790

Budget and Motivation

Managers who keep the actual within the budget should be rewarded in order to motivate them. But
here there should not be any “budget padding”

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 Objective Test Questions

1. Which of the following is not a functional budget?

A. Production budget
B. Distribution cost budget
C. Selling cost budget
D. Cash budget

2. If a company has no production resource limitations, in which order would the following budgets be
prepared?
1 Material usage budget
2 Sales budget
3 material purchase budget
4 Finished goods inventory budget
5 production budget
6 Material inventory budget
A. 5, 4, 1, 6, 3, 2
B. 2, 4, 5, 1, 6, 3
C. 2, 4, 5, 1, 3, 6
D. 2, 5, 4, 1, 6, 3

3. Each unit product Alpha requires 3 kg of raw material. Next month’s production budget for product
Alpha is as follows.
Opening inventories:
Raw materials 15,000 kg
Finished units of Alpha 2,000 units
Budgeted sales of Alpha 60,000 units
Planned closing inventories:
Raw materials 7,000 kg
Finished units of Alpha 3,000 units

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 The number of kilograms of raw materials that should be purchased next month is:
A. 172,000
B. 175,000
C. 183,000
D. 191,000

4. The following details have been extracted from the receivables collection records of C Co.
Invoices paid in the month after sale 60%
Invoices paid in the second month after sales 25%
Invoices paid in the third month after sale 12%
Bad debts 3%

Invoices are issued on the last day of each month. Customers paying in the month after sale are
entitled to deduct a 2% settlement discount. Credit sales values for June to September are budgeted
as follows.
June July August September

$35,000 $40,000 $60,000 $45,000

The amount budgeted to be received from credit sales in September is:

A. $46,260
B. $49,480
C. $50,200
D. $50,530

5. RD Co is in the process of preparing its budgets for 20X2. The company produces and sells a single
product, Z. the budgeted sales units for 20X2 are expected to be as follows.
Jul Aug Sep Oct Nov Dec

6,250 7,000 7,500 7,750 8,000 7,500

The company expects to sell 7,000 units in January 20X3. It is company policy to hold a closing
inventory balance of finished goods equal to 20% of the following month’s sales.
The production budget for Quarter 4 is:
…………………………. Units

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6. The following extracts from the DEF Co budget are available.
Year ended 30 June 20X9 $

Sales 1,135,600

Purchases 751,700

Closing inventory 113,500

Opening inventory 112,250

Opening receivables 163,525

Opening payables 113,550

DEF Co expects that receivables will increase by 12% and that payables will increase by 15% by the
end of the year.
What is the budgeted cash receipts value from customers during the year?
$........................

7. The following extracts from the DEF Co budget are available.

Year ended 30 June 20X9 $

Sales 1,135,600

Purchases 751,700

Closing inventory 113,500

Opening inventory 112,250

Opening receivables 163,525

Opening payables 113,550

DEF Co expects that receivables will increase by 12% and that payables will increase by 15% by the
end of the year.

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 What is the profit mark-up as a percentage of cost of sales?
A. 21%
B. 31%
C. 41%
D. 51%

8. F Co has realized that it will have a temporary cash shortage before it receives the money for a very
large order.
Which TWO of the following actions would be appropriate for F Co to take?
A. Replace non-current assets
B. Arrange an overdraft
C. Pay suppliers early
D. Implement better credit control procedures
E. Increase inventory

9. The following details have been extracted from the receivables records of X:
Invoices paid in the month after sale 60%

Invoices paid in the second month after sales 20%

Invoices paid in the third month after sale 15%

Bad debts 5%

Credit sales for June to August 20X1 are budgeted as follows.

June $100,000
July $150,000
August $130,000
Customers paying in the month after sale are entitled to deduct a 2% settlement discount. Invoices
are issued on the last day of the month.
The amount budgeted to be received in September 20X1 from credit sales is:
A. $115,190
B. $116,750
C. $121,440
D. $123,000

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10. RS is currently preparing the production budget for product A and the material purchase budget for
material X for the forthcoming year. Each unit of Product A requires 5 kg of material X.
The anticipated opening inventory for Product A is 5,000 units and the company wishes to increase
the closing inventory by 30% by the end of the year. The anticipated opening inventory for material
X is 50,000 kg and in order to avoid stock outs the required closing inventory has been increased to
60,000 kg.
The Sales Director has confirmed a sales requirement of 70,000 units of product A.
What will be the purchases budget for material X?
A. 347,500 kg
B. 350,000 kg
C. 357,500 kg
D. 367,500 kg

11. The principal budget factor is the:

A. Factors that limits the activities of the organization and is often the starting point in budget
preparation
B. Budgeted revenue expected in a forthcoming period
C. Main budget into which all subsidiary budgets are consolidated
D. Overestimation of revenue budgets and underestimation of cost budgets, which operates as a
safety factor against risk

12. Which TWO of the following items impact a cash budget?

A. Funds from a bond issue
B. Depreciation
C. Bad debts written off
D. Interest on a loan

The following information relates to questions 13, 14 and 15

Bertram manufacturing Co produces a single product.

Sales of the product in the next four-week period are expected to be 280 units. At the beginning of the
period an inventory level of 30 units is expected, although the budgeted closing inventory level is five
units.

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Each unit of the product requires 2 hours of grade O labour and 3 hours of grade R labour. Grade O labour
is paid $15 per hour, whereas grade R labour receive a guaranteed weekly wage of $280.

Just one raw materials is used in production of the product. A unit of the product requires 7 kg of raw
material. The expected price per kg of the raw material is $50.

13. The budget production level is …………………… units

14. The materials usage budget is ………………. Kg, costing $ …………………...

15. The budgeted cost for grade 0 labour is $ …………………...

16. When preparing a production budget, the quantity to be produced equals:

A. sales + opening inventory + closing inventory
B. sales + opening inventory - closing inventory
C. sales - opening inventory + closing inventory
D. sales - opening inventory - closing inventory

17. The term ‘ budget slack ’ refers to:

A. the extended lead time between the preparation of the functional budgets and the master
budget
B. the difference between the budgeted output and the breakeven output
C. the additional capacity available which can be budgeted for
D. the deliberate overestimation of costs and underestimation of revenues in a budget

18. A flexible budget is:

A. a budget which, by recognising different cost behaviour patterns, is designed to change as the
volume of activity changes
B. a budget for a defined period of time which includes planned revenues, expenses, assets,
liabilities and cash flow
C. a budget which is prepared for a period of one year which is reviewed monthly, whereby each
time actual results are reported, a further forecast period is added and the intermediate period
forecasts are updated.
D. a budget of semi-variable production costs only

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19. A master budget comprises:
A. the budgeted income statement
B. the budgeted cash flow, budgeted income statement and budgeted balance sheet
C. the budgeted cash flow
D. the entire set of budgets prepared

20. Misty Co’s budgetary control report for last month is as follows:
Fixed budget Flexed budget Actual results
$ $ $
Direct costs 61,100 64,155 67,130
Production overheads 55,000 56,700 54,950
Other overheads 10,000 10,000 11,500
126,100 130,855 133,580

The volume variance for last month was $ ……………………………. (Favourable/Adverse)

21.
Budget Actual
700 units 790 units
$29,400 $29,666

Which of the below options are relevant for comparison purposes?

Budget Actual
A. $29,400 $29,666
B. $29,400 $33,180
C. $33,180 $29,666
D. $700 $790

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22. The following extract is taken from the overhead budget of X:
Budgeted activity 50% 75%
Budgeted overhead $100,000 $112,500

The overhead budget for an activity level of 80% would be:

A. $115,000
B. $120,000
C. $136,000
D. $160,000

23. The following extract is taken from the production cost budget of H Co.
Production (units) 2,000 3,000
Production cost ($) 27,400 32,600
The budget cost allowance for an activity level of 4,000 units is:
$ ……………………..

24. QT Co manufactures a single product and an extract from their flexed budget for production costs is
as follows.
Activity level
80% 90%
$ $
Direct material 2,400 2,700
Direct labour 2,120 2,160
Production overhead 4,060 4,080
8,580 8,940
The total production cost allowance in a budget flexed at the 83% level of activity would be, to the
nearest $:
$ ………………………..

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25. Misty Co’s budgetary control report for last month is as follows:
Fixed budget Flexed budget Actual results
$ $ $
Direct costs 61,100 64,155 67,130
Production overheads 55,000 56,700 54,950
Other overheads 10,000 10,000 11,500
126,100 130,855 133,580

The expenditure variance for last month was $ ……………………………. (Favourable/Adverse)

26. The following extract is taken from the production cost budget of S Co.
Production (units) 2,000 3,000
Production cost ($) 11,100 12,900
The budget cost allowance for an activity level of 4,000 units is:
A. $7,200
B. $7,500
C. $13,460
D. $14,700

27. The budgeted and actual figures for B Co are shown for October. B Co uses a marginal costing
system and all direct costs are wholly variable.
Budget Actual
Production/sales units 10,000 12,000
$ $
Direct material 45,000 54,000
Direct labour 30,000 36,000
Variable overhead 20,000 24,000
Fixed overhead 25,000 25,000
Sales revenue 150,000 174,000

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 The profit shown by B Co’s flexed budget for October would be:
A. $11,000
B. $30,000
C. $36,000
D. $41,000

28. A direct mail marketing company is setting the budgets for its next financial year.
In 20X2, costs were $1,077,000. In 20X3, activity was up 10% and costs were $1,100,000. Activity is
expected to increase by 35% of the 20X3 levels in 20X4.
What is the expected total level of costs in 20X4?
$ …………………………..

29. CA Co manufactures a single product and has drawn up the following flexed budget for the year.
60% 70% 80%
$ $ $
Direct materials 120,000 140,000 160,000
Direct labour 90,000 105,000 120,000
Production overhead 54,000 58,000 62,000
Other overhead 40,000 40,000 40,000
Total cost 304,000 343,000 382,000

What would be the total cost in a budget that is flexed 77% level of activity?
A. $330,300
B. $370,300
C. $373,300
D. $377,300

30. The following extract is taken from the production cost budget of S Co.
Production (units) 4,000 6,000
Production cost ($) 11,100 12,900

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 The budget cost allowance for an activity level of 8,000 units is:
A. $7,200
B. $14,700
C. $17,200
D. $22,200

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