Dr Pawan Gupta
Budgetary Control
One of the main functions of management is to control. Budgets are useful in controlling operations. The use of budgets to control operations. Compare actual results with planned objectives.
Budgetary Control
Frequency
Weekly Weekly
Purpose
Primary Recipient(s)
Scrap
Daily
Department Monthly Overhead costs Selling expenses Monthly Income Statement Monthly and quarterly
Determine whether sales Top management and sales goals are being met manager Control direct and indirect Vice president of production labor costs and production department managers Determine efficient use of Production manager materials Control overhead costs Department manager Control selling expenses Determine whether income objectives are being met Sales manager Top manager
TYPES OF BUDGETS
The overall budget is known as the master budget. A master budget normally consists of three types of budgets:
1. Operating Budget
Operating budgets relate to physical activities/ operations such as sales, production, and so on. Operating budget has the following components Sales budget, Production budget, Purchase budget, Direct labour budget, Manufacturing expenses budget, and Administrative and selling expenses budget, and so on.
1) 2) 3) 4) 5) 6)
2. Financial Budget
Financial budgets are concerned with expected cash flows, financial position and result of operations. Financial budget has the following components 1) 2) 3) 4) Budgeted income statement, Budgeted statement of retained earnings, Cash budget, and 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
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 1.Cash sales 2.Collection of accounts receivable 3.Disposal of fixed assets Cash outflows/Disbursements 1. Accounts payable/Payable payments 2. Purchase of raw materials 3. Wages and salary (pay roll) 4. Factory expenses 5. Administrative and selling expenses 6. Maintenance expenses 7. Purchase of fixed assets
The major financial factors/items affecting generation of cash flows are depicted in Exhibit 2.
Exhibit 2. Financial Cash Flow Items Cash inflows/Receipts 1. 2. 3. 4. 5. 6. 7. Loans/borrowings Sale of securities Interest received Dividend received Rent received Refund of tax Issues of new shares and securities Cash outflows/Payments 1. 2. 3. 4. 5. Income tax/tax payments Redemption of loan Re-purchase of shares Interest paid Dividends paid
Example 1 The following data relate to Hypothetical Limited: Balance Sheet as at March 31, Current Year Liabilities Accounts payable (all for March purchases) Taxes payable (all for March income) Share capital Retained earnings Amount Assets Rs 40,000 25,000 11,00,000 10,26,800 Cash Accounts receivable (all from March sales) Inventories: Raw materials (9,600 kgs Rs 3) Finished goods (1,800 units Rs 35) Fixed assets: Cost Rs 20,00,000 Less: Accumulated depreciation (4,50,000) Amount Rs 3,00,000 2,50,000 28,800
63,000
_______ 21,91,800
15,50,000 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 April May June Units sales 9,000 12,000 16,000
3. The management desires closing inventory to equal 20 per cent of the following months sales. 4. The manufacturing costs are as follows Direct materials: (5 kgs Rs 3) (per unit) Direct labour Variable overheads Total fixed overheads (per annum) Rs 15 5 9 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 months 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 Sales (units) Add: Desired closing inventory (0.20 next months sales) Total finished goods requirement Less: Opening inventory Required production (units) 2.Manufacturing Cost Budget Particulars Required production (units) Direct material cost (5 kgs Rs 3 per kg) Total direct material cost Total direct labour cost (Rs 5 per unit) Total variable overhead cost (Rs 9 per unit) Total variable manufacturing costs All fixed manufacturing overheads (Rs 7,20,000 12 months) Total manufacturing cost April 9,600 Rs 15 Rs 1,44,000 48,000 86,400 2,78,400 60,000 3,38,400 April 9,000 2,400 11,400 (1,800) 9,600 May 12,000 3,200 15,200 (2,400) 12,800
3.Purchase Budget (Raw Materials) Particulars Production requirement (units) Raw material required for production @ 5 kgs per unit (kgs) Add: Desired closing inventory (0.20 May requirements) Total requirements Less: Opening inventory Purchase requirement Purchase requirement (amount @ Rs 3 per kg) 4.Selling and Administrative Expenses Budget Particulars Units sales Variable costs @ Rs 5 per unit Fixed costs Total selling and administrative expenses April 9,000 Rs 45,000 20,000 65,000 April 9,600 ______ 48,000 12,800 60,800 (9,600) 51,200 Rs 1,53,600 May 12,800 _____ 64,000
5. Cost of Goods Sold Budget Particulars Units sold Cost per unit Variable Fixed (Rs 60,000 10,000 units) Total cost 6. Budgeted Income Statement for the Month of April Gross sales (9,000 Rs 50) Less: Cash discount (Rs 4,50,000 0.6 0.5 0.02) Net sales Less: Cost of goods sold Gross margin (unadjusted) Less: Capacity variance unfavourable (400 units Rs 6) Gross margin (adjusted) Less: Selling and administrative expenses Earnings before taxes Less: Taxes (0.35) Earning after taxes Rs 4,50,000 2,700 4,47,300 3,15,000 1,32,300 2,400 1,29,900 65,000 64,900 22,715 42,185 April 9,000 Rs 29 6
Rs 35 3,15,000
7.Budgeted Statement of Retained Earnings Opening balance Add: Earnings after taxes Closing balance 8.Cash Budget (April) Opening balance Cash inflows: Collection from debtors: March sales April sales (gross) (Rs 4,50,000 0.60) Rs 2,70,000 Less: Cash discount (Rs 2,70,000 0.5 0.02) 2,700 Cash outflows: Payment to creditors: For March purchases For April purchases (Rs 1,53,600 2/3) Direct labour Variable manufacturing overhead Fixed manufacturing overhead Less: Depreciation Variable selling and administrative overheads Fixed selling and administrative overheads Taxes Closing balance
5,17,300
Rs 8,17,300
9. Proforma Balance Sheet as at March 31, Next Year Liabilities Accounts payable (Rs 40,000 + Rs 1,53,600 Rs 1,42,400) Taxes payable (Rs 25,000 + Rs 22,715 Rs 25,000) Share capital Retained earnings Amount Assets Cash Accounts receivable (Rs 4,50,000 0.40) Rs 51,200 Inventories: Raw material (12,800 Rs 3) 22,715 11,00,000 10,68,985 Fixed assets: Cost Less: Accumulated depreciation ________ 22,42,900 Finished goods (2,400 Rs 35) Amount Rs 4,10,500 1,80,000
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 LtdFlexible Budget (Maintenance Department) Volume (labour-hours) Variable costs: Labour Material Others Mixed costs: Labour Maintenance Other supplies Discretionary fixed costs: Training Experimental methods Committed fixed costs: Depreciation Rent, lease cost Total 4,000 Rs 6,000 2,400 800 2,300 1,400 2,500 1,500 3,500 5,000 3,500 28,900 4,500 Rs 6,750 2,700 900 2,400 1,450 2,750 2,000 4,000 5,000 3,500 31,450 5,000 Rs 7,500 3,000 1,000 2,500 1,500 3,000 2,000 4,000 5,000 3,500 33,000 5,500 Rs 8,250 3,300 1,100 2,600 1,550 3,250 2,000 4,000 5,000 3,500 34,550 6,000 Rs 9,000 3,600 1,200 2,700 1,600 3,500 2,500 4,500 5,000 3,500 37,100
Table 2: Hypothetical LtdFlexible Budget (Manufacturing Department) Volume (machine-hours) Variable costs: Power Helpers Discretionary fixed costs: Training Tools Committed fixed costs: Depreciation Rent Total 1,200 1,000 3,950 1,200 1,000 4,200 1,200 1,000 4,350 1,200 1,000 4,600 1,200 1,000 4,850 800 200 900 200 900 200 900 300 1,000 300 Rs 500 250 Rs 600 300 Rs 700 350 Rs 800 400 Rs 900 450 50 60 70 80 90
Table 3: Hypothetical Department) Volume (labour-hours) Variable costs: Labour Materials Others Mixed costs: Labour Maintenance Other supplies Discretionary fixed costs: Training Experimental methods Committed fixed costs: Depreciation Rent, etc. Total
LtdModified Flexible
Budget (Manufacturing Optimistic 5,000 5,850 Rs 8,775 3,510 1,170 3,425 1,585 2,670 2,250 4,250 5,000 3,500 36,135
Pessimistic Most likely 4,250 Rs 6,375 2,650 850 2,350 1,425 2,625 1,750 3,750 5,000 3,500 30,275
Rs 7,500 3,000 1,000 2,500 1,500 3,000 2,000 4,000 5,000 3,500 33,000
Activity-Based Costing
Costing Products... Direct materials and direct labor costs are easy to trace Overhead cannot be traced easily and must be assigned with estimates
Traditional Costing Methods... Spreads overhead cost over entire customer base Each order appears to cost the same Orders with high profit margins subsidize orders with low profit margins
Traditional Costing Methods... A single or plantwide rate called a predetermined overhead rate is used:
Job Order = Direct Labor Costs Process Cost = Machine Hours
Need for a New System Amount of direct labor used in many industries has decreased Total overhead from depreciation on equipment, utilities, repairs, maintenance has increased
Activity-Based Costing (ABC) An overhead cost allocation system that allocates overhead to multiple activity cost pools and assigns the activity cost pools to products or services by means of cost drivers that represent the activities used.
Activity Any event, action, transaction, or work sequence that causes a cost to be incurred in producing a product or providing a service.
Activity Cost Pool The overhead cost allocated to a distinct type of activity or related activities.
Illustration 4-2
Cost Driver Any factor or activity that has a direct cause-effect relationship with the resources consumed. In ABC cost drivers are used to assign activity cost pools to products or services.
Illustration 4-3
Activity-Based Costing (ABC) Calculate unit cost Identify activities Identify cost driver Compute overhead rate Assign overhead costs
More accurate product costing which necessitates: More cost pools used to assign overhead Enhanced control over overhead Better management decisions