Budgeting
A budget is a set of plans for the coming period, usually a year: how many units to sell and produce, how much material to use and buy, how many labour hours are needed – and, once these are costed, a budgeted profit, financial position and cash position.
This chapter covers why organisations budget, the principal budget factor, the preparation of the functional budgets, the master budget, fixed, flexed and flexible budgets (and the variances between actual and flexed figures), the cash budget, and participation in budget setting.
1 Introduction
Budgeting is an essential tool for management accounting for both planning and controlling future activity. In this chapter we will discuss the benefits of budgeting, the types of budget, and the preparation of budgets.
2 What is budgeting
Most companies prepare budgets – generally once a year they budget for the coming year.
Although this usually includes a forecast Profit Statement for the year, the budget is actually a set of plans.
For example, a manufacturing company needs to plan their material and labour requirements for the coming year. In order to do this they will generally have to forecast their expected sales units for the year i.e. a sales budget. Then they will be in a position to budget their production units for the year i.e. a production budget. Once they have budgeted how many units to produce they are in a position to estimate how much material and how much labour they will require i.e. a materials usage budget and a labour budget.
None of the budgets so far mentioned will be in money terms – they will be expressed in units of production, or kg of material, or hours of labour – but they each represent a plan for the year.
When all the individual budgets (or functional budgets) have been prepared, then it will be possible to cost them out in money terms and prepare a forecast Profit Statement.
3 Benefits of budgeting
Organisations prepare forecasts and plans for several reasons. A budget is not simply a forecast of next year’s profit:
Planning
Budgets force managers to plan ahead – for example how many staff will be needed next year, so that recruitment can start in good time if there are too few (or action can be taken if there are too many), and how much material will have to be bought.
Controlling
Actual results are compared with the budget, usually month by month. If wages were budgeted at $5,000 for January but $6,000 was spent, management wants to know why – and if something has gone wrong it can be corrected before it happens again in later months.
Co-ordination
The budgets of the different departments must fit together. If the sales manager expects to sell 50,000 units but the production manager plans to make 80,000, the plans conflict. The budget makes sure the company produces what it expects to sell, and has the staff and materials needed for that level of production.
Authorising and delegating
Once the budget is agreed it gives managers authority to act. If it says 500 employees are needed, the human resources manager has permission to recruit them without asking again; the responsibility for doing so is delegated to that manager.
Evaluation of performance
The budget gives each manager a target. Actual performance is compared with it: a manager who spends less than budget (for a good reason) has done well and may be rewarded; one who overspends has to explain why.
Communicating and motivating
The budget tells managers what is expected of them, and – especially if performance against budget is rewarded – encourages them to try to do better than budget.
4 Principal budget factor
As previously discussed, the budget needs to be prepared in stages – for example we normally will need to know the budget production (in units) before we can budget how much material will be needed (in kg).
The first thing that the person in charge of the budget process must do is decide where to start! For most companies the starting point will be a sales budget. Once it has been decided how many units the company expects to sell it is then possible to produce a production budget and so on.
However, this will not always be the starting point. Suppose, for example, that the company is a manufacturer of desks for which wood is the main material. Suppose also that during the coming year there is expected to be only a limited supply of wood available. In this situation the starting point will be to budget the amount of wood available, then budget how many units the company is capable of producing (a production budget) and then how many they expect to sell (a sales budget).
In general terms, the first budget to be prepared should be whatever factor it is that limits the growth of the company – it may be the level of demand (so a sales budget will be prepared first) or, as for the example in the previous paragraph, it may be the availability of raw material (so a material budget will be prepared first).
The factor that limits the company is known as the principal budget factor. The management accountant needs to identify the principal budget factor and it is this factor that will be budgeted first.
If materials, labour or machine capacity are in short supply, that is the principal budget factor and is budgeted first; production and sales are then budgeted to fit what is available.
5 The preparation of budgets
The XYZ company produces three products, X, Y, and Z. For the coming accounting period budgets are to be prepared using the following information:
Budgeted sales
Product X 2,000 units at $100 each
Product Y 4,000 units at $130 each
Product Z 3,000 units at $150 each
Standard usage of raw material
Wood (kg per unit) | Varnish (litres per unit) | |
Product X | 5 | 2 |
Product Y | 3 | 2 |
Product Z | 2 | 1 |
Standard cost of raw material | $8 per kg | $4 per litre |
Inventories of finished goods
X | Y | Z | |
Opening | 500 units | 800 units | 700 units |
Closing | 600 units | 1,000 units | 800 units |
Inventories of raw materials
Wood (kg) | Varnish (litres) | |
Opening | 21,000 | 10,000 |
Closing | 18,000 | 9,000 |
Labour
X | Y | Z | |
Standard hours per unit | 4 | 6 | 8 |
Labour is paid at the rate of $3 per hour.
Prepare the following budgets:
(a) Sales budget (quantity and value)
(b) Production budget (units)
(c) Material usage budget (quantities)
(d) Material purchases budget (quantities and value)
(e) Labour budget (hours and value)
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Each budget leads to the next: sales → production → material usage → material purchases, and production → labour. The two adjustments for inventory are:
Budget | Calculation |
Production (units) | Sales + closing inventory of finished goods − opening inventory of finished goods |
Material purchases (quantity) | Material usage + closing inventory of raw materials − opening inventory of raw materials |
These individual budgets, one for each function of the business, are called functional budgets.
6 The Master Budget
After all the functional budgets have been prepared, they are summarised into a master budget for submission to the senior management. This will normally comprise a budgeted statement of profit or loss, a budgeted statement of financial position, a cash budget, and a capital expenditure budget.
Budget statement | What it shows |
Budgeted statement of profit or loss | The planned revenue, costs and profit for the period, built from the sales budget and the costed production, material, labour and overhead budgets. |
Budgeted statement of financial position | The planned assets, liabilities and capital at the end of the period – for example the planned inventories, receivables, payables, non-current assets and cash balance. |
Cash budget | The planned cash receipts and payments, period by period, and the resulting cash balance – a budgeted statement of cash flows (see section 8). |
Capital expenditure budget | The planned spending on new non-current assets (machines, buildings, vehicles), and when it will be paid. These are usually large amounts, so they are planned month by month. |
There are no precise rules for what the master budget contains – it is up to each organisation – but these are the usual statements.
7 Type of budgets
Fixed budget
The original budget, prepared before the period begins for one planned level of activity (sales and production) – usually for the coming year, although it could be for six months, three months or any period. It is the overall target: if the budgeted profit is $100,000, management will look for ways of making at least $100,000.
Flexed budget
The fixed budget rewritten, after the event, for the actual level of activity. Revenue and variable costs are recalculated for the actual sales and production; fixed costs stay as originally budgeted. Comparing actual results with a flexed budget is fair: comparing them with the fixed budget would blame the materials manager for spending more simply because more units were made.
Flexible budget
A budget prepared in a way that can easily be flexed to any level of activity, because its costs are separated into fixed and variable elements (often in a spreadsheet). Many people use ‘flexed’ and ‘flexible’ to mean the same thing.
The difference between an actual result and the flexed budget figure is a variance. A variance that increases profit (more revenue, or less cost, than the flexed budget) is favourable (F); one that reduces profit is adverse (A).
A company has prepared the following fixed budget for the coming year.
Fixed budget | |
Sales | 10,000 units |
Production | 10,000 units |
$ | |
Direct materials | 50,000 |
Direct labour | 25,000 |
Variable overheads | 12,500 |
Fixed overheads | 10,000 |
Total costs | 97,500 |
Budgeted selling price $10 per unit.
At the end of the year, the following costs had been incurred for the actual production of 12,000 units.
$ | |
Direct materials | 60,000 |
Direct labour | 28,500 |
Variable overheads | 15,000 |
Fixed overheads | 11,000 |
Total costs | 114,500 |
The actual sales were 12,000 units for $122,000.
(a) Prepare a flexed budget for the actual activity for the year.
(b) Calculate the variances between actual and flexed budget, and summarise in a form suitable for management.
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8 The Cash Budget
One of the most important budgets for future planning is the cash budget. It is usually prepared on a month-by-month basis showing all the planned receipts and payments of cash each month. It is then possible to see in which months there is likely to be surplus cash and in which months there is likely to be a deficit.
In months where the cash balance is expected to be in surplus, the organisation can plan ahead as to where to invest the money in the short-term. In months where the cash balance is expected to be in deficit they can plan ahead as to how to deal with it - for example, they may need to arrange with the bank to be allowed to go overdrawn, or they may decide to defer planned expenditure on new machines.
The cash budget matters because profit is not the same as cash: a profitable business can still run out of cash if customers pay late, if large payments (new machines, dividends) fall in the same month, or if it is building up inventory. Forecasting the cash position gives management time to act:
Budgeted position | Possible effect on the business | Action that can be planned in advance |
Shortfall (deficit) | Unable to pay suppliers, staff or lenders on time; lost discounts, damaged reputation, interrupted production | Arrange an overdraft or loan with the bank in good time; delay capital expenditure or a dividend; collect cash from customers sooner; pay suppliers later |
Surplus | Idle cash earns nothing | Invest it short-term; repay borrowings; bring forward planned expenditure |
You are presented with the following forecast cash flow data for your organisation for the period November 20X1 to March 20X2. It has been extracted from functional forecasts that have already been prepared.
Nov X1 $ | Dec X1 $ | Jan X2 $ | Feb X2 $ | Mar X2 $ | |
Sales | 80,000 | 100,000 | 110,000 | 130,000 | 140,000 |
Purchases | 40,000 | 60,000 | 80,000 | 90,000 | 110,000 |
Wages | 10,000 | 12,000 | 16,000 | 20,000 | 24,000 |
Overheads | 10,000 | 10,000 | 15,000 | 15,000 | 15,000 |
Dividends | 20,000 | ||||
Capital expenditure | 30,000 |
You are also told the following.
(a) Sales are 40% cash 60% credit. Credit sales are paid two months after the month of sale.
(b) Purchases are paid the month following purchase.
(c) 75% of wages are paid in the current month and 25% the following month.
(d) Overheads are paid the month after they are incurred.
(e) Dividends are paid three months after they are declared.
(f) Capital expenditure is paid two months after it is incurred.
(g) The opening cash balance is $15,000.
Prepare a monthly cash budget for the three months from January to March 20X2.
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9 Participation in the preparation of budgets
There are two basic approaches to the way budgets are prepared:
one approach is for top management to prepare the budgets and then to impose them on their managers. This is known as top-down budgeting
the alternative approach is to get the managers to prepare their own budgets and for top management to then approve them (after obviously due discussion). This is known as bottom-up budgeting.
Top-down (imposed) budgeting | Bottom-up (participative) budgeting | |
Who prepares it | Top management, who hand the budgets to the department managers | Each manager prepares their own budget; top management checks and approves it |
Advantages | Top management keeps control of the targets, and can make sure the budgets fit together | More motivating – managers have a say in their own targets; more realistic, because managers know how their departments work |
Problems | Not motivating – managers may be given targets they know are impossible; less realistic, because top management may not know the detail of each department | Top management must co-ordinate the budgets so they fit together; managers may build in slack (for example budgeting $6,000 when they need $5,000, to beat the target easily), so budgets must be challenged and checked |
10 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Budgeting
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