Assignment No.

2 Use of Various Techniques of

Budgeting

BUDGET:
A budget is a plan for the future. Hence, budgets are planning tools, and
they are usually prepared prior to the start of the period being budgeted.
However, the comparison of the budget to actual results provides valuable
information about performance. Therefore, budgets are both planning tools
and performance evaluation tools.

Budgets are part of a company's long-range planning system. While some

portions of a long-range plan are concerned with the organization in five to
ten years, the budget is the short-range portion of the plan. The following
figure 1.1 shows that how the budgetary process fits into an overall general
framework of planning, decision-making and control.

1. Establish objectives

2. Identify potential courses of action (i.e. strategies)

Long-term planning
process 3. Evaluate alternative strategic options

4. Select alternative courses of action

5. Implement long-term plan in the form of the annual budget

Annual budgeting
process 6. Monitor actual results

7. Respond to divergencies from plan

Figure 1.1 The role of long-term planning and budgeting

within the planning, decision-making and control process

A budget is a quantitative plan for the future that assists the organization in
coordinating activities. All large organizations prepare budgets. Many
organizations prepare detailed budgets that look one year ahead, and budgets
that look further into the future that contain relatively less detail and more
general strategic direction.

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Assignment No.2 Use of Various Techniques of
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MULTIPLE FUNCTIONS/USES OF BUDGETS:

Budgets serve a number of useful purposes. They include:
1. planning annual operations;
2. coordinating the activities of the various parts of the organization and
ensuring that the parts are in harmony with each other;
3. communicating plans to the various responsibility centre managers;
4. motivating managers to strive to achieve the organizational goals;
5. controlling activities;
6. evaluating the performance of managers.

Planning

The budgeting process ensures that managers do plan for future operations,
and that they consider how conditions in the next year might change and
what steps they should take now to respond to these changed conditions.
This process encourages managers to anticipate problems before they arise,
and hasty decisions that are made on the spur of the moment, based on
expediency rather than reasoned judgment will be minimized.

Coordination

The budget serves as a vehicle through which the actions of the different
parts of an organization can be brought together and reconciled into a
common plan. Without any guidance, managers may each make their own
decisions, believing that they are working in the best interests of the
organization.

Communication

Through the budget, top management communicates its expectations to

lower level management, so that all members of the organization may
understand these expectations and can coordinate their activities to attain
them.

Motivation

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Assignment No.2 Use of Various Techniques of
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The budget can be a useful device for influencing managerial behavior and
motivating managers to perform in line with the organizational objectives. A
budget provides a standard that under certain circumstances, a manager may
be motivated to strive to achieve.

Control

A budget assists managers in managing and controlling the activities for

which they are responsible. By comparing the actual results with the
budgeted amounts for different categories of expenses, managers can
ascertain which costs do not conform to the original plan and thus require
their attention.

STAGES IN BUDGETING PROCESS:

The important stages are as follows:

1. communicating details of budget policy and guidelines to those people

responsible for the preparation of budgets;
2. determining the factor that restricts output;
3. preparation of the sales budget;
4. initial preparation of various budgets;
5. negotiation of budgets with superiors;
6. coordination and review of budgets;
7. final acceptance of budgets;
8. ongoing review of budgets.

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Assignment No.2 Use of Various Techniques of
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USES OF VARIOUS BUDGETING

TECHNIQUES
MASTER BUDGETING
The most common budgeting technique is to create a master budget which is
the overall collection of budgets for the operation of the organization. It
consists of the budgets for sales, manufacturing costs (materials, labor, and
overhead) or merchandise purchases, selling expenses, and general and
administrative expenses. These budgets are fixed, static or expected budgets.

Sales budget

The sales budget is the starting point in putting together a comprehensive

budget for a business. It includes the number of units to be sold and the
selling price per unit. It is important to agree to the sales budget first because
many other budgets are based on this data. Although its components are
simple, getting a management team to agree on the number of units to be
sold and the selling price per unit, the two items needed to prepare the
budget, is often difficult and time- consuming. The Pickup Trucks Company,
which makes trucks, has just completed its budgeting process for next year.
Total expected sales are 100,000 trucks at a price of Rs.15.00 each. Its sales
budget has been prepared on a quarterly basis as follows:

The Pickup Trucks Company Sales Budget For the Year Ended December 31, 20X1
Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
Units 15,000 17,000 28,000 40,000 100,000
Selling Price Rs.15 Rs.15 Rs.15 Rs.15 Rs.15
Total Sales Rs.225,000 Rs.255,000 Rs.420,000 Rs.600,000 Rs.1,500,000

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In addition to annual and quarterly sales budgets, monthly budgets are often
prepared so sales can be tracked against expectations more frequently than
once every three months.

Manufacturing costs
Before preparing the direct materials, direct labor, and manufacturing
overhead budgets, the production budget must be completed.

Production budget. The production budget shows the number of units that
must be produced. To budget for annual production, three things must be
known: the number of units to be sold, the required level of inventory at the
end of the year, and the number of units, if any, in the beginning inventory. If
quarterly budgets are required, this same information is needed on a
quarterly basis. Using the Pickup Trucks Company's quarterly sales budget
and given that 15% of the next quarter's sales volume must be on hand
before the quarter begins, the production budget by quarter can be prepared.
Further assumptions are a 10% increase in sales in quarter one of next year
compared to the current year's quarter-one sales and 2,250 units in inventory
at the beginning of the year.

Pickup Trucks Company Production Budget in Units for 20X1

Sales 15,000 17,000 28,000 40,000 100,000

Required Ending Inventory 2,550 4,200 6,000 2,475 2,475
Units Required 17,550 21,200 34,000 42,475 102,475
Beginning Inventory (2,250) (2,550) (4,200) (6,000) (2,250)
Units to be Produced 15,300 18,650 29,800 36,475 100,225

Direct materials budget. The direct materials budget determines the

number of units of raw materials to be purchased. It uses the number of units
to be produced from the production budget, the required level of ending
inventory for raw materials, and the number of units in beginning inventory.
Once the number of units to be purchased is determined, it is multiplied by
the cost per unit to determine the budgeted amount for raw materials
purchases. The Pickup Trucks Company requires 10% of next quarter's
production requirement for raw materials to be in its ending inventory. For
example, because it takes five tires to make the special pickup truck (four

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plus the spare tire mounted on the side), at a cost of Rs.0.50 per tire, the raw
materials purchases budget calculates 501,890 tires required at a cost of
Rs.250,945. The units in the production budget are adjusted for units in
ending and beginning inventories, multiplied by five (number of tires per
pick up) to determine total tires to be purchased and then multiplied by
Rs.0.50 to determine the cost of the tires needed. As a reminder, the
production budget showed the following units for 20X1:

Units
Quarter 15,300
1
Quarter 18,650
2
Quarter 29,800
3
Quarter 36,475
4
Total
100,22
5
Pickup Trucks Company Raw Materials Budget For the Year 20X1
Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
Units to be produced 15,300 18,650 29,800 36,475 100,225
Number of tires per unit ×5 ×5 ×5 ×5 ×5
76,500 93,250 149,000 182,375 501,125
Required ending 9,325 14,900 18,238 8,415 8,415
inventory
Total units required 85,825 108,150 167,238 190,790 509,540
Beginning inventory (7,650) (9,325) (14,900) (18,238) (7,650)
Units to purchase 78,175 98,825 152,338 172,552 501,890
Cost per unit × × × × ×
Rs.0.15 Rs.0.15 Rs.0.15 Rs.0.15 Rs.0.15
Cost of raw materials Rs.11,726 Rs. 14,824 Rs. 22,851 Rs. 25,883 Rs. 75,284
purchases

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This process is repeated for all the other raw material components used in
producing a pickup truck.

Direct labor budget. The direct labor budget shows the number of direct
labor hours and the cost of the labor to determine the total cost of direct
labor. Assume it takes one-half hour of labor to put together one pickup
truck and each labor hour costs Rs.14.00. The total direct labor budget is for
50,113 (100,225 units × .5 hours per unit) hours at a cost of Rs.701,575
(Rs.14.00 per hour × 50,113 hours). The break out by quarter is shown in
the following table.

Pickup Trucks Company Direct Labor Budget For the Year 20X1
Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
Units to be 15,300 18,650 29,800 36,475 100,225
produced
Direct labor hours × .5 × .5 × .5 × .5 × .5
per unit
Total direct labor 7,650 9,325 14,900 18,237.5 50,112.5
hours
Cost per hour × × × × ×
Rs.14.00 Rs.14.00 Rs.14.00 Rs.14.00 Rs.14.00
Cost of direct Rs.107,100 Rs.130,550 Rs.208,600 Rs.255,325 Rs.701,575
labor

Manufacturing overhead. The manufacturing overhead budget identifies

the expected variable and fixed overhead costs for the year (or other period)
being budgeted. The separation between fixed and variable costs is
important because the Pickup Trucks Company uses a predetermined
overhead rate for applying overhead to units produced. In preparing its
budget, the Pickup Trucks Company has identified the following variable
and fixed costs: indirect materials Rs.0.50 per unit, indirect labor Rs.1.00 per
unit, maintenance Rs.0.75 per unit, annual depreciation Rs.12,000,
supervisory salaries Rs.24,000, and property taxes and insurance Rs.21,000.
The budget by quarter is:

Pickup Trucks Company Manufacturing Overhead Budget For the Year 20X1

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Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total

Variable Costs
Indirect Materials Rs.7,650 Rs.9,325 Rs14,900 Rs.18,238 Rs.50,113
Indirect Labor 15,300 18,650 29,800 36,475 100,225
Maintenance 11,475 13,988 22,350 27,356 75,169
Total Variable Costs 34,425 41,963 67,050 82,069 225,507
Fixed Costs
Supervisory Salaries 3,000 3,000 3,000 5,700 14,700
Property Taxes and 6,000 6,000 6,000 6,000 24,000
Insurance
Depreciation 5,250 5,250 5,250 5,250 21,000
Total Fixed Costs 14,250 14,250 14,250 16,950 59,700
Total Manufacturing Rs.48,675 Rs.56,213 Rs.81,300 Rs.99,019 Rs.285,207
Overhead
Total Direct Labor Hours 7,650 9,325 14,900 18,238 50,113
Predetermined Overhead Rs.5.70
Rate

Selling expenses budget

The budget for selling expenses includes the variable and fixed selling
expenses. The variable expenses in the selling expenses budget are usually
based on sales dollars. Assume the Pickup Trucks Company's variable
expenses are sales commissions and delivery expense. Sales commissions
are 4% of sales dollars, and delivery expense, also called freight out by some
companies, is Rs.0.10 per unit sold. The company also has fixed sales
salaries of Rs.50,000. The calculations for sales commissions and delivery
expense, followed by the selling expenses budget, are shown in the
following tables.

Pickup Trucks Company Sales Commission and Delivery Expenses Budget

Calculations For the Year 20X1

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Sales Commission
Expense
Sales Rs.225,000 Rs.255,000 Rs.420,000 Rs.600,000 Rs.1,500,000
Commission Rate 4% 4% 4% 4% 4%
Sales Rs.9,000 Rs.10,200 Rs.16,800 Rs.24,000 Rs.60,000
Commissions

Delivery Expense
Units Sold 15,000 17,000 28,000 40,000 100,000
Cost per Unit Rs.0.10 Rs.0.10 Rs.0.10 Rs.0.10 Rs.0.10
Delivery Expense Rs. 1,500 Rs. 1,700 Rs. 2,800 Rs. 4,000 Rs.10,000
Pickup Trucks Company Selling Expenses Budget For the Year 20X1

Variable Expenses
Sales Commissions Rs. 9,000 Rs.10,200 Rs.16,800 Rs.24,000 Rs. 60,000
Delivery Expense 1,500 1,700 2,800 4,000 10,000
Total Variable Expenses 10,500 11,900 19,600 28,000 70,000
Fixed Expenses
Sales Salaries 12,500 12,500 12,500 12,500 50,000
Total Selling Expenses Rs.23,000 Rs.24,400 Rs.32,100 Rs.40,500 Rs.120,000

General and administrative expenses budget

The general and administrative expenses budget details the variable and
fixed operating expenses for the general and administrative areas of the
company. The Pickup Trucks Company has no variable administrative
expenses. Its fixed expenses include salaries of Rs.60,000, rent expense of
Rs.15,000, and office supplies of Rs.6,000.

Pickup Trucks Company General and Administrative Expenses Budget For the Year
20X1

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Variable Expenses
None
Fixed Expenses
Salaries Rs.15,000 Rs.15,000 Rs.15,000 Rs.15,000 Rs.60,000
Rent Expense 3,750 3,750 3,750 3,750 15,000
Office Supplies 1,500 1,500 1,500 1,500 6,000
Total General and Rs.20,250 Rs.20,250 Rs.20,250 Rs.20,250 Rs.81,000
Administrative Expenses

Budgeted Income Statement

The budgeted or budgeted income statement is prepared after the operating
budgets have been completed. The cost of goods sold on the income
statement is calculated using the per unit cost of Rs.11.25, which consists of
Rs.1.40 per unit for direct materials, Rs.7.00 per unit for direct labor, and a
manufacturing overhead rate of Rs.2.85. The overhead rate is calculated by
multiplying the predetermined overhead rate of Rs.5.70 per direct labor hour
times the direct labor hours per unit of one-half hour.

Quantity Unit Cost Total Cost

Direct Materials Various Rs. 1.40 Rs. 1.40
Direct Labor .5 hour 14.00 7.00
Manufacturing Overhead .5 hour 5.70 2.85
Total Unit Cost Rs.11.25
Pickup Trucks Company Budgeted Income Statement For the Year 20X1

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Sales (100,000 × Rs.15) Rs.1,500,000

Cost of Goods Sold (100,000 × Rs.11.25) 1,125,000
Gross Profit 375,000
Operating Expenses
Selling Expenses Rs.120,000
Administrative Expenses 81,000
Total Operating Expenses 201,000
Income from Operations 174,000
Interest Expense 2,880
Income before Income Taxes 171,120
Income Taxes (40%) 68,448
Net Income Rs.102,672

CASH BUDGETING
The cash budget indicates how much cash the company will have on hand at
the end of each period, and also indicates when the company will need to
borrow funds to cover temporary cash shortfalls, and when the company will
have excess funds to invest in short-term financial instruments.

The objective of the cash budget is to ensure that sufficient cash is

available at all times to meet the level of operations that are outlined in the
various budgets. Cash flow is so important that in some organizations, cash
balances are projected for the end of each week, or even on a daily basis.

Often, the cash budget is assembled from supporting schedules. These

schedules show, for the period being budgeted, anticipated cash
disbursements and cash receipts that arise from (1) operating activities, (2)
additions and disposals of fixed assets, and (3) financing activities.

The cash budget is one of the most important planning tools that an
organization can use. It shows the cash effect of all plans made within the
budgetary process and hence its preparation can lead to a modification of

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budgets if it shows that there are insufficient cash resources to finance the
planned operations.

It can also give management an indication of the potential problems that

could arise and allows them the opportunity to take action to avoid such
problems. A cash budget can show four positions. Management will need to
take appropriate action depending on the financial position.

Cash Position Appropriate management action

Pay creditors early to obtain discount.
Short term surplus Attempt to increase sales by increasing debtors and stocks.
Make short term investments.
Increase creditors.
Short term deficits Reduce debtors.
Arrange an overdraft.
Make long term investments.
Expand operations
Long term surplus
Diversify.
Replace / update fixed assets
Raise long term finance. i.e. issue shares
Long term deficit
Consider shut down or disinvestment opportunities.

ZERO-BASED BUDGETING
In the normal budgeting process, the previous year's level of expenditure is
often assumed to have been appropriate. The task of individuals preparing
the budget is to decide what activities and funds should be added or
subtracted. Such a process builds into an organization a bias towards
continuing the same activities year after year.

Zero-base budgeting, in contrast, enables the organization to look at its

activities and priorities afresh. The previous year's resource allocation is not
automatically considered as the basis of this year's allocation. Instead, each
manager has to justify anew his/her entire budget request.

Uses of Zero-Based Budgeting

1. Efficient allocation of resources, as it is based on needs and benefits.
2. Drives managers to find cost effective ways to improve operations.

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3. Detects inflated budgets.

4. Useful for service departments where the output is difficult to identify.
5. Increases staff motivation by providing greater initiative and
responsibility in decision-making.
6. Increases communication and coordination within the organization.
7. Identifies and eliminates wasteful and obsolete operations.
8. Forces cost centers to identify their mission and their relationship to
overall goals.

Disadvantages of Zero-Based Budgeting

1. Difficult to define decision units and decision packages, as it is time-
consuming and exhaustive.
2. Forced to justify every detail related to expenditure. The R&D
department is threatened whereas the production department benefits.
3. Necessary to train managers. Zero-based budgeting must be clearly
understood by managers at various levels to be successfully
implemented. Difficult to administer and communicate the budgeting
because more managers are involved in the process.
4. Honesty of the managers must be reliable and uniform.

FLEXIBLE BUDGETING
A flexible budget is a budget that is prepared for a range i.e. for more than
one level of activity. The flexible budget is also known as a variable,
dynamic, sliding scale, step budget. The underlying principle for a flexible
budget is that every business is dynamic and ever changing. Thus, a flexible
budget is developed for a range, say 8000-10000 units of production. Under
this approach, if the actual production is 9000 units compared to the
projected amount of 10000 units, the manager uses the flexible budget to
project the costs for 9000 units of output in place of the budgeted 10000
units. The flexible budget covers a range of activity, is easy to change with a
variation in production levels, and thus facilitates correct performance
measurement and reporting.

Steps in flexible budgeting

The following steps are involved in developing a flexible budget:

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1. Deciding the range of activity to which the budget is to be prepared

2. Determining the cost behavior patterns (fixed, flexible, semi-
variable) for each element of cost to be included in the budget
3. Selecting the activity levels in terms of production levels to prepare
budgets at those levels
4. Preparing the budget at the pre-determined level of activity

Uses of flexible budgets

The following are the main uses of a flexible budget:

• Accurate budgeting- Flexible budgets result in the preparation of

more accurate budgets. Such budgets consider the output and
accordingly estimate the costs to be incurred at that level of output
• Accurate performance measurement- Flexible budgeting
incorporates changes in activity levels and compares actual
performance with the budget in terms of output achieved. This
facilities more meaningful comparison and evaluation of performance.
• Coordination- Flexible budgeting results in proper coordination
between various departments of a company. For instance, if
production is planned in relation to estimated sales, materials and
labor are acquired to meet expected production needs
• Control tool- Such a budget acts as a control tool. Comparisons
between the budgeted costs (at the actual production level) and actual
costs form the basis for analyzing cost variances and fixing
responsibility for the same.

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