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5/26/2018 Lecture 6
1/25Leeds University Business School
Management Accounting
Lecture 6
Budgets for planning
Dr. Mohammad Alhadab
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Aims and objectives
By the end of this lecture, you should be able to understand
the following:
The role of budgets in management accounting
Budgeting process
Purposes of budgets
Planning
Control
Motivation
Behavioural aspects of budgets Preparation of budgets
Example
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Budgeting process
Co-ordinate various functions of the organisation via use of financial
plans: referred to as budgets
Co-ordinating process is referred to as the budgetary process
Definition
Preparation of a quantitative statement of expectations regarding theallocation of the organisation's resources
Objective
Provide a formal, quantitative & authoritative statement of the firm'splans
Main purposes of budgets are for planning, control & motivation But, may be conflicting objectives
Budgetary systems can & do influence behaviour & actions
But, not always in an anticipated or even desirable direction
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Purposes of budgets
1. Plann ing Budgets represent financial expressions of formal plans - concerned
with the future
Budgets used to;
allocate resources
co-ordinate activities
communicate management plans to lower levels
2. Con tro l Essential that the outcomes are reported & monitored to ensure that
the objectives of the organisation are being met
Control systems Communications networks that monitor activities& provide basis for corrective action
Planned outputs compared with the actual results
identify deviationsvariance analysis
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Responsibility accounting
Managers held responsible only for those costs & revenues theycontrol
Guidelines
If can control quantity & price manager responsible for alltheexpenditure incurred.
If can control quantity, but not price manager responsible fordifference due to usage.
If expenditure is uncontrollablemanager should notbe responsible.
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Purposes of budgets
3. Motivat ion
Budgetsstandards of achievement to which top management aspire
target to which managers may be motivated to strive to achieve
frequently used as a means of motivating individual managers &employees
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Behavioural aspects of budgets
Use of budgets as a motivat ion target
Goal congruence
individuals internalise goals of organisation
satisfying own goals
satisfying organisations goals
Budgets do not motivation if individuals feel alienated from the goalsof the organisation
managers & employees should participate in the budget settingprocedure.
But - participation may allow individuals to incorporate bias into thebudget creating slack budgets.
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Level of difficulty in attaining target
Past performance major factor in determining the abilityof the budget to motivate
Repeated failures to achieve a goal
individual lowers expectationsnegative effect on present & future performance
Success in meeting reasonable goals in the past
higher aspiration levels in the future & motivation
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Conf l ic t ing ro les o f budget ing
Organisation rewards linked to managers budget record Manager's bonus or promotion prospects dependent on ability to meet
the budget targets used as a key motivating factor
But - accounting performance measures only approximate measures of
desired outcomes (Otley 1987)
Dysfunctional consequences If performance measures motivate managers to engage in behaviour not
in organisations best interest
lack of goal congruence
Actual behaviour may be affected so that the desired results are
reported, but achieved in undesirable ways which affect the firms longerterm performance
Many aspects of performance cannot be adequately measured inquantitative terms
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Preparation of budgets
Production budget (in units)Sales in month X
Add: Closing stock of finished goods X
X
Less: Opening stock of finished goods (X)
Production in month X
Raw materials purchases budget
Materials required for production in month X
Add: Closing stocks at end of month XX
Less: Opening stocks at start of month (X)
Material purchases in the month X
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Cash budget
Raw materials purchase payments budget
Materials purchases are not the same as cash payments
Need to consider the credit terms allowed
Other cash payments
Budgeted cash payments entered in the cash budget for themonth in which the payment is expected to occur
Exclude- non-cash costs such as depreciation
Include- cash payments for fixed assets
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Cash budget
NB: Remember - accruals concept.
Sales Based on the number of units sold in the period
Not the cash received in respect of sales
Need to allow for any discounts given
Cost of goods sold Based on the sales in the period
Not on cash paid in respect of goods sold, nor on the productioncarried out in the period if stocks of finished goods are held
Other expenses Based on expenses incurred in the period
Not on cash payments made
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ABC Ltd has just developed an entirely new product which does not fit in with its
existing range. It has therefore decided to set up A Ltd, as a wholly owned
subsidiary to produce and market this product. 750,000 is to be provided by ABC
LTD at the beginning of month 1 through an issue of ordinary shares in A Ltd; any
further finance required by A Ltd will also be provided by ABC Ltd in the form of an
interest-free fluctuating loan.
Plant for the new company, installed in rented premises, will cost 200,000 and be
completely written off over an estimated life of 5 years. It will be paid for at the
end of month 2.
Production will be so regulated, commencing in month 1, that the stock of finished
goods at the end of each month will be equal to the next two months budgeted
sales.
The first few monthssales are budgeted as follows:
Month 1 zero unitsMonth 2 20,000 units
Month 3 36,000 units
Month 4 54,000 units
and thereafter, at 50,000 units per month.
Normal annual production will 600,000 units (that is, 50,000 units per month).
Example - ABC LTD
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One quarter of each monthssaleswill be for cash with the remaindersold on one
monthscredit. Selling price will be 10 per unit.
Budgeted product and administrative costs are as follows:Material 2 per unit
Labour and variable manufacturing
overheads 5 per unitAnnual fixed manufacturing overheads
(allocated to units output on the basisof normal annual production)
900,000 (including plant depreciation)
Annual selling and administrative
overheads (fixed) 760,000 Material purchases are made just before the end of each month in such a way
that the closing stock each month will exactly satisfy the next three monthsproduction requirements. A special purchase will be made at the beginning of
month 1 sufficient for the first three months production requirements.
Suppliers of material allow an average 1 monthscredit. Wages and variables
manufacturing overheads will be paid in the month in which they are incurred,
and all outlays on fixed overheads will be paid quarterly in advance.
Example - ABC LTD- continued
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Required:
1. For each month of the first three months of A Ltdsoperations:
(a) Calculate the number of units of finished product produced.
5 marks
(b) Calculate the value of materials purchases and the amount paid to the suppliers
of material.
5 marks(c) Calculate the amount of cash received in respect of sales.
5 marks
(d) Prepare a cash budget including the payments made by, and to, the holding
company. 10 marks
2. Calculate the cost per unit based on normal production and prepare a budgetedProfit and Loss Account for As first quarter year and its budgeted Balance Sheet as at
the end of that period 45 marks
3. Comment briefly on A Ltdsprojected performance. 30 marks
Total 100 marks
Example - ABC LTD- continued
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(a)- Production Budget (units)
Month 1 Month 2 Month 3 Month 4 Month 5
Sales 0 20,000 36,000 54,000 50,000
Closing Stock 56,000 90,000 104,000 100,000 100,000
Total 56,000 110,000 140,000 154,000 150,000
Less: Opening Stock 0 56,000 90,000 104,000 100,000
Production 56,000 54,000 50,000 50,000 50,000
(b)-Raw Material Purchases Budget ()
Month 1 Month 2 Month 3 Month 4 Month 5
Materials Required 112,000 108,000 100,000 100,000 100,000
Closing Stock 308,000 300,000 300,000 300,000 300,000
Total 420,000 408,000 400,000 400,000 400,000
Less: Opening Stock 0 308,000 300,000 300,000 300,000
Purchases 420,000 100,000 100,000 100,000 100,000
ABC LTD- question 1 solutions
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(b)- Purchases Payment Budget ()
Month 1 Month 2 Month 3 Month 4 Month 5
Initial Purchases(for first three months 112+108+100) 320,000
Previous month's purchases 100,000 100,000 100,000 100,000
Total payment 420,000 100,000 100,000 100,000
(c)- Sales Receipt Budget ()
Month 1 Month 2 Month 3 Month 4 Month 5
Sales Revenue
(10/unit) 200,000 360,000 540,000 500,000
Cash Sales (25%) 50,000 90,000 135,000 125,000
Debtors (75%) (1 Month credit) - 150,000 270,000 405,000
Sales Receipts: - 50,000 240,000 405,000 530,000
ABC LTD- question 1 solutions
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(d)- Cash Budget
Month 1 Month 2 Month 3 Month 4 Month 5
Receipts:
Capital Issue 750,000 - - - -
Sales Revenue - 50,000 240,000 405,000 530,000
Total Receipts 750,000 50,000 240,000 405,000 530,000
Payments:
Plant - 200,000 - - -Purchases - 420,000 100,000 100,000 100,000
Labour (5 * units produced) 280,000 270,000 250,000 250,000 250,000
Fixed Manuf. OH 225,000 (150/600*900,000) see note (1) at the end
Fixed Adm&Sales OH 190,000 (760,000/4)
Less: Depreciation - (10,000) (200,000/5/4) see note (2) at the endTotal Payments 685,000 890,000 350,000 350,000 350,000
Cash Surplus/ Deficit 65,000 -840,000 -110,000 55,000 180,000
Opening Balance - 65,000 - - -
Borrowing - 775,000 110,000 - -
ABC LTD- question 1 solutions
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Cost Per Unit
Materials 2.00
Labour 5.00
Manuf OH (900,000 / 600,000) 1.50
Total Cost / Unit 8.50
Budgeted P& L Account
1st Quarter
Sales (20,000 month 1 2 sales + 36,000 month 2 3 sales) 560,000
Less: Cost of goods sold (20,000+36,000 ) * 8.5 (see cost per unit above) 476,000
Gross Profit: 84,000
Less: Selling & Admin (760,000 / 4 quarters) 190,000
Overabsorbed Fixed Manuf OH see note (3) at the end -15,000 175,000
Net Loss: -91,000
ABC LTD- question2 solutions
E l ABC LTD 2 l ti
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Budgeted Balance Sheet
Fixed Assets:
Plant: Cost of Purchase 200,000
Less: Depreciation 10,000 190,000
Current Assets:
Stocks:
Finished Goods (104,000 units from Prod Bud x 8.5) 884,000
Raw Materials (from Raw Material Budget) 300,000 1,184,000
Debtors (from Sales Receipt Budget) 270,000
1,454,000
Less: Current Liabilities
Creditors (from Purchases Payment Budget) 100,000
Loan from ABC LTD ( from Cash Budget 775,000+110,000) 885,000 985,000
469,000
Total Assets: 659,000
Represented by:
Share Capital 750,000
Less: Net Loss 91,000
659,000
Example - ABC LTD- 2 solutions
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Normal Budgeted P& L Account
1st Year
Sales (600,000 units* 10) 6,000,000
Less: Cost of Goods Sold (600,000 units* 8.5) 5,100,000
Gross Profit: 900,000
Less: Selling & Adminstrative Costs 760,000Net Profit (EBITDA) 140,000
'Normal' return on equity capital = (140/750) = 18.66%
However:
1. Ignores 'start-up' performance and initial borrowing.
2. Ignores inflation or specific increases in costs.
3. Ignores possible future demand changes with effects on selling price.
4. Need data covering a longer time period to complete an estimated discounted cash
flow analysis.
ABC LTD- question 3 solutions
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Notes:
Note (1)-How to calculate fixed manufacture overhead (Fixed Manuf. OH) for the first
three months?
- It is indicated in the question that the annual fixed manufacturing overheads are
allocated to units output on the basis of normal annual production.
-Also, as indicated in the question, the normal annual production will 600,000 units
(that is, 50,000 units per month).
So, the annual fixed manufacturing overheadsto the first three months should as
follows
Fixed Manuf. OH for the first three months = (150,000 / 600,000 ) X 900,000
= 220,000 225,000150,000 = 50,000 X 3 months
600,000 = 50,000 X 12 months
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ABC LTD-
Note (2)-
How to calculate annual depreciation for fixed assets?
Annual Depreciation = cost of assets / life of assets
= 200,000 / 5 years
= 40,000But the question requires to prepare the cash budget for the first three months
of the year (1stquarter). Thus, we divide the annual depreciation by 4 (each
year has 4 quarters).
Depreciation for the first three months (1stquarter) = 40,000 / 4
=10,000
Or you can divide the annual depreciation by 12 months and then times 4 as
follows 40,000 / 12months= 3,333.33
Then 3,333.33 X 3 months = 10,000
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Note (3)-
How to calculate Overabsorbed Fixed Manuf OH ?
Overabsorbed Fixed Manufacturing Overheads=
(Production in first three months -normal production )* fixed overheads per unit
Production in first three months = 56,000 + 54,000 + 50,000 units
=160,000 units
Normal production = 600,000 units / 4 = 150,000 units
Fixed overhead per unit = 900,000 / 600,000 units= 1.5
Overabsorbed Fixed Manuf OH = (160,000150,000) * 1.50
= 15,000
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Recommended reading:
Chapter 13, Weetman