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Chapter 16

Budgeting

PowerPoint presentation by Anne AbrahamUniversity of Wollongong

©2009 John Wiley & Sons Australia, Ltd

BUDGETING BASICS

• A budget is a formal written statement of management’s plan for specified future time period, expressed in financial terms

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• The budget is used as a basis for:– Controlling operations– Evaluating performance

• A budget promotes efficiency and serves to deter waste and inefficiency

Budgeting and accounting

• Accounting is used to express budgetary goals in financial terms

• Budgets use historical data on revenues, costs and expenses

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, p• Periodic budget reports are prepared

which management uses to compare actual results with planned objectives

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What role does an accountant play in the budgeting process and what business objectives are aligned to budgeting?

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Benefits of budgeting

1. Requires management to plan ahead2. Provides definite financial objectives

for all levels of responsibility3. Creates an early warning system for

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problems4. Facilitates coordination of activities5. Results in greater management

awareness of operations and external factors

6. Contributes to positive behaviour patterns

Essentials of effective budgeting

• Clearly defined areas of authority and responsibility

• Realistic goals• Acceptance by all levels of

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Acceptance by all levels of management

• Participation by managers in setting budgets

• Review of differences between actual and expected results

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What are the key steps a business must consider when formulating a budget?

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Length of the budget period

• A budget may be prepared for any period of time

• Most common budget period is one year

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y• This annual budget is often

supplemented with quarterly and monthly budgets

The budgeting process

• The development of next year’s budget begins before end of current year

• The budget starts with a sales forecast which should consider:

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– General economic conditions– Industry trends– Market research studies– Anticipated advertising and promotion– Previous market share– Changes in prices– New products– Technological developments

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How would you describe the budget process?

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Budgeting and long-range planning

• Long-range planning is a formalised process of – Selecting strategies to achieve long-

term goals, and

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– Developing policies and plans to implement the strategies

• Usually encompasses 3–5 years• Long-range budgets

– Contain less detail than annual budgets– Have a strategic emphasis

What specific budgets are prepared? For whom and by whom?

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The master budget

• The master budget is a set of interrelated budgets

• It consists of: – Operating budgets (sales and production)

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which lead to the budgeted income statement

– Financial budgets (cash budget and budgeted balance sheet) that are concerned with cash resources for expected operations and capital expenditure

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PREPARING THE OPERATING BUDGETS

1. Sales budget2. Production budget3. Direct materials budget4 Direct labour budget

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4. Direct labour budget5. Manufacturing overhead budget6. Selling and administration expense

budget7. Cash budget

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Sales budget

• This budget is based on the forecast of sales revenue for the budget period

• It acts as a starting point for master budget

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g• It shows expected unit sales volume

times anticipated unit selling price• It sets activity levels for other functions

(e.g. production, purchasing)

Production budget

• This budget shows the units to be produced in order to meet expected sales

• It involves realistic estimates in order to

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avoid insufficient or excessive ending inventory

Direct materials budget

• This budget estimates quantity and cost of materials to be purchased

• Budgeted cost of direct materials is calculated by multiplying required units

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y p y g qof material times anticipated cost per unit

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Direct labour budget

• This budget estimates quantity (hours) and cost of labour needed for production requirements

• The budget is calculated by multiplying required labour hours (from production

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required labour hours (from production budget) times anticipated hourly wage rate

• It involves realistic estimates of labour force required for anticipated level of production activity

Manufacturing overhead budget

• This budget distinguishes between variable and fixed overhead costs

• Variable overhead costs fluctuate with changes to production volume

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g p• Total fixed overhead costs are

estimated, then divided by cost driver to establish per-unit rate to be applied to production

Selling and administrative expense budget

• This budget distinguishes between variable and fixed expenses

• Variable expenses based on budgeted unit sales

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• Fixed expenses based on assumed costs for the period

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Cash budget

• This budget shows anticipated cash flows

• It combines ending cash balance from previous period plus details from other

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budgets• The annual cash budget is often

detailed on monthly basis to reflect anticipated levels of activities

• It helps plan for cash excesses and shortfalls

Cash budget continued

• The cash budget has three sections:– Cash receipts: expected cash inflows

from customers, interest, dividends, planned sales of assets and shares

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– Cash payments: expected cash outflows for direct materials and labour, overheads, selling & administration costs, taxes, dividends, assets

– Financing: expected cash borrowings and repayments of borrowings

PREPARING THE BUDGETED FINANCIAL STATEMENTS

• The final stage in the preparation of the master budget is to prepare the budgeted financial statements

• These are:

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– Budgeted income statement– Budgeted balance sheet

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Budgeted income statement

• The budgeted income statement is the end product of the operating budgets

• It shows expected profitability for budget period

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• It combines individual operating budgets plus additional expenses (e.g. interest, taxes)

• It forms a basis for performance evaluation

Budget balance sheet

• This is a projection of the financial position at end of budget period

• It combines the previous period’s budgeted balance sheet and budgets

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g gfor current period (sales, direct materials, direct labour, overheads, selling and administration budgets)

• The format is similar to that prepared for external users

BUDGETING IN NON-MANUFACTURING ENTITIES

• Budgeting is not limited to manufacturing entities

• Budgets may also be used in profit planning by a range of other entities:

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p g y g– Merchandising entities– Service entities– Not-for-profit entities– Government entities

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Merchandising entities

• Sales budget is the starting point• Sales budget drives the master budget• Master budget incorporates

departmental budgets

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departmental budgets• Purchases budget used instead of

production budget• Purchases budget shows estimated

cost of goods needed to meet sales

Merchandising entities continued

• Formula for determining budgeted purchases:

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Service entities

• Expected output drives master budget• Levels of staff planned to match

anticipated levels of service• Profitability affected by:

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y y– overstaffing (excessive labour costs)

and – understaffing (client dissatisfaction thus

low revenue)• Service revenue determined by billing

time and services offered

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Not-for-profit entities

• Budgeting involves planned expenditure to fund activity index usually drives master budget

• Budget is often prepared on cash basis,

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g p p ,not accrual basis

• Management task is to find sufficient cash receipts for planned expenditure

Government entities

• Budgeting involves plannedexpenditure to cover various programs drives master budget

• Revenues come from taxes, rates or

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,user-pays service charges

• Some assets are obtained as part of private developments

BUDGETARY CONTROL

• Budgetary control refers to the use of budgets to control operations by comparing actual results with planned objectives

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• Comparisons occur at regular intervals: daily, weekly or monthly as required

• Budget reports provided feedback about the progress of planned activities

• Differences are analysed so plans can be modified if necessary

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BUDGETARY CONTROL continued

• Budgetary control components:

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Static budget reports

• Project budget data at one level of activity only

• Actual results compared with anticipated level of activity

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• Unfavourable (U) results occur when actual revenue below or actual expenses above targets

• Favourable (F) results occur when actual revenue above or actual expenses below targets

Static budget reports continued

• Management determines significance (materiality) of differences

• This is followed by investigation of reasons for U or F differences

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• Appropriate corrective actions depend on causes for differences

• May not be appropriate for performance evaluation because of differing activity levels from master budget or costs changing for various activity levels

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Flexible budgets

• Project budget data for various levels of activity

• Flexible budgets are static budgets at different activity levels

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• Master budget adapts to changing operating conditions

• Total fixed costs do not change as activity levels change

• Total variable costs do change as per-unit activities change

Developing the flexible budget

1. Identify activity index and relevant range

2. Identify variable costs and budgeted costs per unit

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p3. Identify fixed costs and establish

budgeted amounts4. Prepare budget for selected levels of

activity within relevant range

Flexible budget reports

• Two sections for analysing production and cost control:– Production data (e.g. direct labour

hours)

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– Cost data (for fixed and variable costs)• Both actual and budgeted costs are

based on same activity level• Flexible budgets are widely used in

production and service departments

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Management by exception

• Budget reports reviewed when actual and budgeted results differ significantly

• Management focus on problem areas• Two guidelines are generally used to

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Two guidelines are generally used to identify level of significance:– Materiality: variance from budget by

more than a predetermined amount– Controllability: ability of manager to

influence item

THE CONCEPT OF RESPONSIBILITY ACCOUNTING

• Involves accumulating and reporting costs and revenues on the basis of the managers with authority to make decisions concerning the itemsPersonalises management accounting

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• Personalises management accounting systems

• Performance reports relate only to controllable items

• Effectiveness can be measured and reported at all management levels

THE CONCEPT OF RESPONSIBILITY ACCOUNTING continued

• Especially valuable in a decentralised entity

• Decentralisation means that control has been delegated to many individual

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g ymanagers throughout the organisation

• A segment is an area of responsibility within decentralised organisation

• Each manager prepares regular reports for individual area of responsibility

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How are the key strategies of Queensland Health communicated to the health service

areas?

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THE CONCEPT OF RESPONSIBILITY ACCOUNTING continued

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Controllable vs. non-controllable revenues and costs

• All cost or revenue items are controllable at some level of responsibility

• All costs are controllable at the top

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p• Costs are less controllable as one

moves down through levels of management

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Controllable vs. non-controllable revenues and costs continued

• Direct costs are generally controllable in areas where incurred

• Indirect costs are generally allocated and are therefore not controllable

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Responsibility reporting system

• Reports are prepared for each area of responsibility starting at the lowest level of responsibility

• They are collated and summarised as

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one progresses upwards through levels of responsibility

• Costs and revenues are identified as controllable at appropriate levels

• Management by exception is possible at each level

TYPES OF RESPONSIBILITY CENTRES

Cost centres• Incur costs but do not directly generate

revenues• Managers evaluated on ability to control

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Managers evaluated on ability to control costs

• Examples:– production departments – service centres

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TYPES OF RESPONSIBILITY CENTRES continued

Profit centres• Incur costs but also generate revenues• Managers evaluated on profitability of

their centres

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their centres• Examples:

– Individual departments of a retail store– Branch offices of banks

TYPES OF RESPONSIBILITY CENTRES continued

Investment centres• Incur costs, generate revenues and

have control over investment funds available for use

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• Managers evaluated on:– Profitability of the centre– Rate of return earned on funds invested

• Often associated with subsidiary companies

Responsibility accounting for cost centres

• Performance is evaluated by comparing actual controllable costs to flexible budget data

• No distinction between fixed and

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variable costs• Controllability is the key issue

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Responsibility accounting for profit centres

• Managers evaluated on profitability• Fixed costs may be direct or indirect

– Direct fixed costs are traceable to responsibility centre and often

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p ycontrollable

– Indirect fixed costs are allocated to profit centres and are not controllable

Responsibility accounting for profit centres continued

• Responsibility report shows budgeted and actual controllable revenues and costs

• Report shows controllable margin

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p gi.e. Contribution margin

less controllable fixed costs• Non-controllable fixed costs not

reported

Responsibility accounting for investment centres

• Manager can control or influence investment funds

• Manager is usually evaluated on return on investment (ROI)

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( )• ROI only includes factors controllable

by investment centre manager

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Responsibility accounting for investment centres continued

• Responsibility reports include budgeted and actual ROI below controllable margin

• Report is affected by extent of manager’s responsibility

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p y• Investment centres are independent of

operations, so fixed costs are controllable and included

• ROI can be affected by valuation of assets and which profitability measure is used

Principles of performance evaluation

Behavioural principles• Involvement of managers in setting

budget goals• Performance evaluation based only on

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controllable items• Support of top management for

evaluation process• Provision for manager to respond• Identification of both good and poor

performance

How are the key performance measures of Queensland Health determined? What about

within each of the health service areas?

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Principles of performance evaluation continued

Reporting principles• Contain only data controllable by

manager• Use of accurate and reliable budget data

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Use of accurate and reliable budget data• Highlight significant differences between

actual and budget results• Preparation at reasonable intervals• Reports designed for intended purposes

Decision Toolkit

• Reebles Ltd• Work through on your own and check

your results with the suggested solution provided

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p

Demonstration Problem

• Glenda Ltd• Work through on your own and check

your results with the suggested solution provided

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p

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