Prepare and monitor basic operating and financial budgets

BS508 Accounting Principles

QUOTE

Budget: A mathematical confirmation of

your suspicions.

• A.A. Latimer

Budget Definition 1:

• A budget is a detailed plan in writing (usually expressed in monetary terms) that outlines the expected financial consequences of management’s strategies for achieving the organisation’s key objectives for the coming period.

Budget Definition 2:

• A budget is a financial document that expresses a future plan or expectation contributing to the operation or control of an organisation (e.g. expressing the expected future cash flows or setting out the expected sales quantities or revenues for a future period).

Why Budget ?

• to be able to PLAN(eg. resource requirements, so that you have them when youneed them)

and• to be able to CONTROL

(ie. monitor how you’re going, to ensure that you stay on-track to achieve your plans)

• Budgeting is a necessary element in the process of management

Planning & Controlling

• PLAN ing è via a MASTER BUDGET (static)

• CONTROL ing è via a FLEXIBLE BUDGET (dynamic)

MASTER BUDGET• A set of interrelated budgets representing a

comprehensive plan of action for a specified time period.

• Basically, the master budget is a combination of all the individual budgets in an organisation, including the operating and financial budgets.

Master Budget for Stylistic Furniture

Advantages of Budgets

• Budgeting forces management to plan ahead.• Realistic performance targets are set against which

actual performance can be compared.• Budgeting assists all segments of the organisation to

work towards the same goals.• Budgeting contributes to better communication

through the exchange of financial information between departments.

• Budgeting improves motivation by providing goals to be aimed for.

Limitations of Budgeting• B are unable to provide up-to-date information in a fast-

changing environment.• B focus too much on short-term financial targets rather

than value-adding activities.• B limit innovation by lower level managers• B is too focussed on the functions rather than the processes

of the business.• B encourages incremental thinking, i.e. adding a percentage

to last year’s figures, rather than strategic planning.• Budgets can encourage using up the whole budgeted

amount, irrespective of need.

What is Budget Slack?

• Budgets may be set in such a way that they are useless as either a control tool or a motivator. A manager who sets a budget that is known to be achievable without stretching (this is known as budget slack) has gone through the motions of budgeting but has not entered into the spirit of setting achievable but challenging targets.

• On the other hand, unrealistically high targets act as a disincentive for staff and may produce resentment and reduce motivation. (SMART goals)

Types of Budgets• Individual budgets that make up the master budget are often

classified as revenue budget, operating budgets or financial budgets.

1. Revenue budgets set out the estimates of the income of the firm (e.g. sales, fees and other income).

2. Operating budgets set out the estimates of the costs associated with different aspects of the operations of the firm (e.g. purchases budget, cost of goods sold budget, selling expenses budget, administration expenses budget and financial expenses budget).

3. Financial budgets set out the estimates of financing activities and the expected summary results for the coming period (e.g. cash budget, income statement budget, balance sheet budget and capital expenditure budget)

The Process of Budgeting& the Interrelationships of Budgets

• Market Research/Trend Analysis/Demand Forecasting

• Operating Budgets

• Capital Exp Budgets• P & L Statement Budgets

• Cash Flow Budgets

• Balance Sheet Budgets

Operating Budgets1. Revenues (Sales) Budget2. Production Budget3. Materials Purchases Budget4. Direct Labour Budget5. Manufacturing Overhead Budget6. Non-Manufacturing Costs (Operating)

Budgets BUDGETED INCOME (P&L) STATEMENT

Sales Budget

SALES(in units)

= required PRODUCTION = required (in units)

Sales

Production Budget

+ Required Closing Stock- Opening Stock

Direct Labour Budget

Manufacturing Overhead Budget

(in units & $'s)

Materials Purchases Budget

PURCHASES

Required for production+ Required Closing Stock

- Opening Stock

(in hours & $'s)

for example:

Sales Budget

SALES 100 100 290kg(in units) +50 + 80kg

- 5 - 60kg= required PRODUCTION = 145 = required = 310kg

(in units)

= 72.5hrs

Required for production+ Required Closing Stock

- Opening Stock

(in hours & $'s)

(in $'s)

Sales

Production Budget

+ Required Closing Stock- Opening Stock

Direct Labour Budget

Manuf. O'head Budget

(in units & $'s)

Materials Purchases Budget

PURCHASES

@ 2kg

@ ½ hr

Operating Budgets

• Illustrative Example:

• Brentware Ltd (a manufacturer of clay pots)

Projected Data for 1st Qtr. 200X

a). Product SpecificationsRaw (Direct) Materials - clay 8 kg. per pot $0.50 per kg

Direct Labour 0.5 hrs. per pot $10 per hour

b). Projected Sales Jan Feb Mar Apr May

Projected Sales units pots 1200 2000 2400 2600 2700

Projected Selling price $15.00 per pot

c). Projected Inventories Jan Feb Mar Finished Goods: Beginning pots 1800 Ending ► enough for next mths. sales x 1.5

Raw (Direct) Materials: Beginning clay kgs 9600 Ending ► enough for next mths. prodn.

d). Projected Overheads Variable Manuf. O/head Costs:

electricity, maintenance, indirect labour etc $2.00 per labour hour Fixed Manuf. O/head Costs: Jan Feb Mar total

insurance, depreciation, salaries etc $3,500 $3,500 $4,250 $11,250

e). Projected Selling & Admin Expenses variable items (eg vary in relation to revenues):

sales commissions, bad debts, etc fixed items:

rent, salaries, vehicle exps, etc

f). Projected Tax Rate 40%

$2,000 $2,500

BRENTWARE LTD - a manufacturer of clay pots

$2,500

Quantities Costs

per schedules

Operating Budgets for 1st Qtr. 200XJan Feb Mar

1. Revenues BudgetUnits sales 1200 2000 2400

Selling price $15 $15 $15Total $18,000 $30,000 $36,000

2. Production Budget Apr

Planned Sales pots 1200 2000 2400 2600

+ Required Closing Stock 3000 3600 3900 4050

- Opening Stock -1800 -3000 -3600 -3900= Production pots 2400 2600 2700 2750

total pots =

3. Materials Purchases BudgetRequired for production pots X 8kgs 19200 20800 21600 22000

+ Required Closing Stock 20800 21600 22000- Opening Stock -9600 -20800 -21600

=Purchases kgs 30400 21600 22000

Purchases ($) @ $0.50 $15,200 $10,800 $11,000

4. Direct Labour BudgetProduction pots 2400 2600 2700

X standard labour input (.50hrs/pot) std. lab. hrs = 1200 1300 1350X standard labour rate ($10/hr) $12,000 $13,000 $13,500

5. Manufacturing Overhead BudgetVariable Manufacturing Overhead Budget:

std. lab. hrs = 1200 1300 1350X standard variable overhead rate (per dir lab hr) $2.00 $2,400 $2,600 $2,700

Fixed Manufacturing Overhead Budget: total

per schedule $3,500 $3,500 $4,250 $11,250

Total Manufacturing Overheads $5,900 $6,100 $6,950

6. Selling & Administration Budgetvariable items (eg vary in relation to revenues):

sales commissions, bad debts, etcfixed items:

rent, salaries, vehicle exps, etc

7700

$2,000 $2,500 $2,500per schedules

Inventories Budgets ($'s) for 1st Qtr. 200X Raw (Direct) Materials: Jan Feb Mar

Beginning @/kg $0.50 $4,800 $10,400 $10,800Ending @/kg $0.50 $10,400 $10,800 $11,000

Finished Goods: CostUnit Costs - per unit

Raw (Direct) Materials 8 kg @ $0.50 per kg $4.00 Direct Labour 0.5 hrs @ $10.00 per hour 5.00 Variable Manuf O/head Costs 0.5 labour hrs @ $2.00 per labour hr 1.00 Fixed Manuf O/head Costs $1.46 per unit 1.46

$11.46Fin Goods Inventory Valuations - Jan Feb Mar

Beginning Inventory @ $11.46 $20,628 $34,380 $41,256Ending Inventory @ $11.46 $34,380 $41,256 $44,694

BUDGETED INCOME (Profit & Loss) STATEMENTJan Feb Mar

Revenues $18,000 $30,000 $36,000

less Cost of Goods Sold:Opening Stock - Finished Goods $20,628 $34,380 $41,256

+ Cost of Goods Manufactured (see below*) 27,500 29,500 31,250less Closing Stock - Finished Goods -34,380 -41,256 -44,694

= Cost of Goods Sold 13,748 22,624 27,812

Gross Profit $4,252 $7,376 $8,188

less Operating Expenses Selling and Administration Expenses -2,000 -2,500 -2,500

Net Profit before Tax $2,252 $4,876 $5,688less Income Tax Expense -901 -1,950 -2,275

Net Profit after Tax $1,351 $2,926 $3,413

*Cost of Goods Manufactured: Direct (Raw) Materials:

Opening Stock $4,800 $10,400 $10,800+ Purchases 15,200 10,800 11,000

- Closing Stock -10,400 -10,800 -11,0009,600 10,400 10,800

Direct Labour 12,000 13,000 13,500 Manuf Overheads 5,900 6,100 6,950

27,500 29,500 31,250

Quantities Rates

$11,250 ÷ 7700 units =

*Cost of Goods Manufactured:

Purchases Budget Exercise

• Jesse idol’s DVD sales business• Jesse expects to sell 7000 DVDs in October and 7800

in November.• Jesse requires that the physical stock on hand at the

end of each months (i.e. closing inventory) equals 25% of the sales expected for the next month.

• Jesse buys the DVDs for $15 each and sells them for $30 each.

• Create the Purchases Budget for October.

Jesse idol’s Purchases Budget

• Cost/unit $50 + (100% mark-up)$50 = $100 SP• Projected Sales for July 5,600 units

– August 6,200 units• Opening Stock: 1 July 1400 (25% of July Sales)• Closing Stock : 31 July 1550 (25% of Aug Sales)• a) Purchases for July: 5600 + 1550 – 1400 =

5750 units x $50 = $287,500

Jesse idol’s Purchases Budget

• Sales 560,000• Less COS:

– Open Inv. 70,000 (1400 x $50)

– + Purchases 287,500– Clos Inv (77,500) 280,000Gross Profit $280,000

Variances

• A Variance is the difference betweena budgeted amount and the actual

amount• Budgeted amounts may be based on:• past costs (but considering future changed conditions &/or past inefficiencies)

• expected costs• best practice• “standards” (a combination of expected conditions & best practices)

Budgets• Static Budget – is the original budget based on the original

planned level of output (ie. the master budget level)- used for resource planning purposes

• Flexible Budget – is the static budget restated for the actual level of output achieved– used for analysis, after the ‘actuals’ have occurred,

for performance evaluation purposes►– enables a proper comparison of “apples with apples”

• A simple example of this concept:Assume you are the Functions Catering Manager at a large hotel → see next slide

Booking for a wedding reception

Expected number of guests 100 guests Master (Static) Budget for 100 guests(for planning purposes)

Quoted Price $30 per guest Revenue $3,000Est Costs: food, beverages, labour, etc $20 per guest Costs 2,000Expected Profit $10 per guest Profit $1,000

Actual number of guests 120 guests Actual Results for 120 guestsRevenue $3,600Costs 2,280Profit $1,320

Static Budget Actual VarianceCosts 2,000 2,280 -280

Flexible Budget Actual VarianceRevenue ($30 x 120) $3,600 $3,600 0Costs ($20 x 120) $2,400 2,280 120 Favourable cost control ?? - YESProfit ($10 x 120) $1,200 $1,320 120

Functions Catering Dept - Cartman's Hotel

Evaluation ??

Evaluation ??

OR should the Evaluation be:

Evaluation of Cost Performance ??

Unfavourable - Poor cost control ??

Variance Analysis

Prices Prices Price Variances X X

Quantities Quantities Qty Variances

Variances

Budget(plan)

ActualsVariances

(for evaluation of performance)

Costs Costs

For example: your petrol budget for next week

Budget ▼

Actuals ▼

Variances

10 c 12 c Price variance (2 c) x 300 km = $(6) U

x x

200 km 300 km Qty variance (100) km x 10 c = $(10) U

▼ ▼

$20 $36 Total variance = $(16) U

Formulas

to calculate variances: Price Variance = price diff. x actual qty

Qty Variance = qty. diff. x budgeted price

Exercise

• Lampa Ltd manufactures lamps. It has set up the following standards per finished unit for direct materials and direct labour:Budget Actual Variances

$4.50/kg $5/kg Price Variance

$0.50x 12kg = $(6) U

x x

10 kg 12 kg QtyVariance

2kg x $4.50 = $(9)U

= =

$45 $60 Total Variance =$(15)U