Chapter 3: Information for budgeting, planning and control purposes

Learning Objectives
After studying this chapter, you should be able to:
1. Indicate the benefits of budgeting.
2. State the essentials of effective budgeting.
3. Identify the budgets that comprise the master budget.
4. Describe the sources for preparing the budgeted income statement.
5. Explain the principal sections of a cash budget.
6. Indicate the applicability of budgeting in nonmanufacturing companies.
Budgeting is critical to financial well-being. As a student, you budget your study time and your
money. Families budget income and expenses. Governmental agencies budget revenues and
expenditures. Business enterprises use budgets in planning and controlling their operations. The
primary focus in this chapter is budgeting - specifically, how budgeting is used as a planning tool
by management. Through budgeting, it should be possible for management to maintain enough
cash to pay creditors, to have sufficient raw materials to meet production requirements, and to
have adequate finished goods to meet expected sales. The content and organization of Chapter 2
are as follows.

3.1.Concepts of Budgeting
Budgeting involves planning for different revenue producing and cost generating activities of an
organization. The importance of budgeting is emphasized by an old saying, "Failing to plan is like
planning to fail." Budgeting is essentially financial planning, or planning for financial
performance. Financial performance depends on revenue and cost. Revenue is provided from sales
of merchandise by retailers, sales of products, harvested, mined, constructed, formed, processed or
assembled by farms, mining companies, construction companies and manufacturers
and from sales of various services by firms involved in activities such as banking, insurance,
accounting, law, medical care, food distribution, repair and entertainment. In addition to producing
revenue, all of these companies generate three types of costs including discretionary, engineered
and committed costs. Various costs fall into one of these three categories based on the cause and
effect relationships involved. Although there are a variety of ways to define costs, categorizing
costs in terms of the cause and effect relationships is a prerequisite for understanding the different
types of budgets.
 Discretionary costs have two important features: (1) They arise from periodic (usually
annual) decisions regarding the maximum amount to be incurred, and (2) they have no
measurable cause-and-effect relationship between output and resources used. There is often a
delay between when a resource is acquired and when it is used. Examples of discretionary
costs include advertising, executive training, R&D, and corporate-staff department costs such
as legal, human resources, and public relations. Unlike engineered costs, the relationship
between discretionary costs and output is a black-box because it is non-repetitive and non-
routine.
 Engineered costs result from a cause-and-effect relationship between the cost driver -output
- and the (direct or indirect) resources used to produce that output. Engineered costs have a
detailed, physically observable, and repetitive relationship without put.
 Committed costs - Decisions concerning potential investments are made using discounted
cash flow techniques. For example, capital budgeting such as investing in new plant and
equipment.

3.2.The Basic Framework of Budgeting

A budget is a comprehensive and detailed quantitative expression of plan in outlining and
utilizing economic resources of an entity for some specified period of time. Plan refers to future
goal(s) set to be achieved. Therefore, budget represents this plan for the future expressed in formal
quantitative terms. The process of preparing a budget is termed as budgeting.

The budgets of a business firm serve much the same functions as the budgets prepared by
individuals informally. The main difference is that business budgets tend to be more detailed,
involve more work in preparation, and are formal. The following three features basically
characterize budget. These are:
3.2.1. Budget is quantitative
3.2.2. Budget deals with some specific entity
3.2.3. Budget covers a period of time in future

1. Budget is Quantitative: A significant amount of descriptive material may accompany a

budget. However, from accounting point of view we are interested primarily on the
quantitative description of activities expressed by the budget. In budget preparation all
Planned activities for an organization are reduced to common denominator of money, or other
quantitative measures such as units of inputs and outputs.
2. Budget deal with entity: A specific budget must apply to a clearly defined accounting
entity. The entity could be an individual, a family, or an organization. For budgeting purpose
entity may consist of small parts of a business entity, and hence budgets could be prepared
for a section, a unit, a department, a division, a branch, or for specific activity of an entity.
Organizations must clearly define each entity for which they prepare budgets. For example,
if a firm wants to prepare departmental budgets, the functions and activities involved in each
department within the firm must be clearly identified and delineated carefully.
3. Budget is Future Oriented: Budget quantifies plans. Plans are set goals or objectives to be
achieved in future time period. Therefore, budget represents the expected financial
consequences of planned programs and activities for a specified period of time.
Organizations may prepare weekly budgets, monthly budgets, annual budgets (wide spread
one) or some other specified future time period.

Why Budgeting?
Budgeting is the process of matching the needs to be achieved with the economic resources in a
systematic and cohesive way. People budget for a number of reasons, but the main reason is the
economic resource constraints they face to achieve their desire or need. Some of the reasons for
budgeting in business and other organizations are discussed in the following paragraphs.

a) Periodic Planning Requires Budgeting: Almost all activities of organizations require

some planning to ensure efficient and effective use of scarce economic resources. Planning
is an important prerequisite to almost all successful activities. Budgeting process creates a
formal planning framework that provides specific, uniform periodic deadlines for each
phase of the planning process.

b) Budgeting enhances coordination, cooperation and communication: The budgeting

process provides the vehicle for the exchange of ideas and objectives among people in
various organizational segments (hierarchies). A budget prepared properly provides a
standard of performance expected from employees before they begin their duties. Ideally a
budget is prepared on participative management style. Every segment should be invited to
have an input in the budget and the final budget should be accepted by all parties involved in
its implementation as a frame of reference in their activity. A budget should not be
considered as an imposition from top to bottom. Each party involved should know and strive
to achieve the set budget through coordination of resources and cooperation. Budget is,
therefore, a target of performances of employees.
c) Budgeting provides a frame of reference for performance evaluation: Budgets are
estimates of future events. Hence, they serve as a realistic estimate of acceptable
Performance for an entity. If a budget is not used, there is no standard against which actual results
can be compared. This year’s performance could be better than the actual performance of last year.
But the last year’s performance cannot be considered as a benchmark for performance evaluation.
Probably the current years could have been better than what it is. Moreover, the last year’s
performance might have included inefficiencies, which are currently avoided. Thus, comparison of
a previous period’s performances with the current ones may lead to misleading conclusions.
Managerial performance in each budgeting entity could be appraised by comparing actual
performance with budget projections. Last year’s sales of birr 10 million cannot be considered as a
basis for evaluating performance of this year’s sales of birr 12 million. A birr 2 million increases
in sales cannot be said as good sales because with current year’s inputs used the sales could have
been, let’s say birr 16 million. Probably the firm might have invested huge amount of many in
promoting sales this year with the expectation of sales volume of birr 16 million. Since operating
conditions differ from period to period, past data should not be considered as a basis of
performance evaluation. Managers want to know whether they have achieved their expectations or
not.

d) Budgeting creates awareness of business costs: Accountants and financial managers are
by their very nature concerned with the cost implications of decisions and activities. But
many other managers are not concerned. For example, a production supervisor is highly
concerned primarily with the quality of outputs while the marketing manager is concerned
mainly with sales volume. In such situations, people easily forget about cost and cost-
benefit relationships. However, during the budget preparation, all managers with budget
responsibility must think in terms of cost and benefit as they evaluate their projects and
activities from the organization’s point of view as a whole. The cost awareness provides a
common ground for communicating among various functional areas of the organization.

e) Budget forces managers to think ahead of time: In running organizations, there are a
number of unforeseen factors, which critically influence the performance of the
organization. In preparing a budget, organizations often find that the budgeting process
indicates potential areas of problems where corrective actions might be needed in advance
before the problem is actually faced and the organization’s activities are jeopardized.
Through budgeting process, therefore, managers prepare themselves to tackle potential
problems they might face. For example, when developing a sales budget the manager may
identify unexpected decline in sales volume in the coming year. The manager, therefore,
thinks in advance how to avoid the sales fall down or if it is impossible to increase sales
prices, he should think of reduction in production or purchase of goods so as to minimize
storage costs and probable damage due to long time storing of goods in the warehouse.
Another example is by preparing a cash budget; a manager may identify excessive cash on
hand next year. In such a case, he would think of investing idle cash and generate additional
income. Generally, budget guides and urges managers what they should do in the coming period.

f) Budget satisfies legal and contractual requirements: Many organizations are legally
required to prepare a budget. All government units are required to develop their own
budgets even though no much use is derived from the budgets. Some firms commit
themselves to a budgeting requirement when signing contractual agreements like signing
loan agreements. For example, a bank may require the creditor to submit annual operating
budget and cash budget throughout the life of the bank loan.

3.3.Types of Budget and Their Major Features

Four types of budget are used for planning and controlling the various types of costs. These four
techniques are summarized below in the table.

Budget Types And Characteristics

Type of Budget Characteristics Type of Cost Examples
A maximum amount is Employee training, advertising,
Appropriation established for certain Discretionary sales promotion and research
Budget expenditures based on costs. and development.
management judgment.
The static amount The static part: salaries,
A static amount (a) is (a) includes both depreciation, property taxes
established for fixed costs discretionary and and planned maintenance. The
and a variable rate (b) is committed costs flexible part: direct material,
Flexible Budget
determined per activity while the flexible direct labor and variable
measure for variable costs, part (b) includes overhead. Also, some costs
i.e., y = a + bx engineered costs related to sales reps such as
per "x" value. sales commissions and travel.
Decisions concerning
Capital Budget potential investments are
Committed costs. New plant and equipment.
made using discounted cash
flow techniques.
A comprehensive plan is Discretionary, All revenue and expenditures
Master Budget developed for all revenue engineered and for any company.
and expenditures. committed costs.

3.4.The Master Budget: An Overall Plan

The master budget is a summary of all phases of a company’s plans and goals for the future. It is a
set of budgets prepared collectively for all activities of a company. Different companies may
prepare different individual budgets. But all firms do have their own master budget. The master
budget is a network consisting of many separate budgets, which are interdependent.
 3.4.1.Time Frames of Budgets/ Length of budget period
Budgets are prepared with some time frame. The time frame varies depending on the type of
budgets to be prepared. Generally, budgets can be grouped into two depending upon the longevity
of time they cover. These are: Short-term budgets, and Long-term budgets

Short-term budgets are prepared to formally express the short-term plans in quantitative terms.
Usually a year is considered as a short-term plan period. Depending upon the seasonal patterns of
business a firm might develop budgets quarterly, monthly, or even weekly for some important
factors. For example, a firm may develop a monthly cash flow budgets. A typical short-term
budget covering one year period would be divided into quarters. The first quarter budget would
then be divided into monthly budgets. Then, towards the end of the succeeding quarter, the next
quarter budget will be divided into monthly segments. Postponing the division of quarter’s budgets
into month's leads to more accurate results because more recent data are available by the time the
monthly figures are prepared.

Another method to prepare a short-term budget is to add a month when one month covered by the
budget ends. Such type of budget is called continuous budget. Each month, the managers add an
additional month to the budget thus keeping a twelve-month budget always available. For
example, a firm may prepare a budget for a year covering (from Hamle to Sene). In continuous
budgeting, this firm will add the budget for the coming Hamle by the end of the current Hamle, by
the end of Nehassie the one month budget would be added (next year’s Nehassie) and so on.
Continuous budgeting keeps the firm’s plan ahead and the firm will have 12 months budget at any
time. If the firm prepares only annual budgets, the firm will have guidance only for 12 months at
the beginning and a month or two as it approaches the end of the budget period. The budgeting
process involves a great deal of work and the use of continuous budgeting spreads it throughout
the year instead of concentrating it near the end of each year.

Long-term budgets are prepared to quantify formally the long-term planning, also called strategic
planning, which is a process of setting long-term goals and determining the means to achieve
them. Short-term planning is concerned with the operating details of the next fiscal period or year
but long-term planning addresses broader issues such as developing new product line, replacement
of plants and equipment, and other issues which require years of advance planning. Long-term
budgets, therefore, could have a time frame of 5 years to 10 years even more range. A capital
budget is an important part of long-term planning. Some budgets are oriented not to specific time
period but to events. These are typical project budgets. However, project budgets usually cover
more than one-year period and are long-term budgets.

3.4.2.Master Budget Classification

Budgets are sometimes called pro-forma statements because they are forecasted financial
statements in contrast to statements prepared using actual data. The master budget can be
Classified in operational budgets and financial budget. Operational budgets focus on the
operational activities of the firm and financial budget focuses on the effect that operational budget
and other plans such as capital expenditures and repayment of debt will have on cash.

Operating budget is accompanied by the following schedules.

3.4.2.1. Sales budget
3.4.2.2. Production budget
3.4.2.3. Production cost budget
3.4.2.4. Ending inventory budgets
3.4.2.5. Selling and Administrative costs budget
3.4.2.6. Budgeted income statement.

Financial Budget includes:

a) Cash budgets including receipts and disbursements.
b) Budgeted balance sheet.

3.4.3.Relationship among Budgets

The sub units of the master budget are interdependent. For example, the sales forecast could be
influenced by the amount that the firm is willing to spend on advertising and sales promotion. In
turn, these expenditures are dependent on the sales forecast. The interrelationships are very
complex. For example, production managers develop production budgets from sales budgets and
might find that they could not produce the required level of output because of shortages of inputs
- Labor, material, or other inputs. The process would then have to be started again and firms might
be obliged to change their strategies regarding a particular product. The change in policy could be
to raise prices or lower promotional expenses. There could be similar to-and-from movements
between sales budgets and credit policy, and virtually all other budgets and policies. For example,
changing credit terms from a 60 day to 30 day payment in an effort to collect cash rapidly could
adversely affect sales and profits, as could reduce the quantity of inventory of finished goods to
save interest expense.

3.4.4.Developing the Master Budget

Once the sales budget and the relationships among sales and the other critical variables are known
or assumed, the actual development of the master budget is primarily a technical analysis. The
mechanics can be done using computer or on a manual basis. The method used does not lead to
correct or wrong budget figures. Using computers for computation does not guarantee the
correctness of budgets. What is critical is whether the assumed relationship actually prevails
among budget items. There are two basic errors, which may lead to a wrong budget figures. These
are:
First, the formulation of the budget could be logically wrong. For example, the person setting up
the relationship between cash collections and credit sales as “cash collections from credit sales will
be 30% in the month of sales and 80% in the month following the sales,” is logically wrong
because this statement means that the company would collect 110% of its sales (30% + 80% =
110%) which is impossible.

Second, the formulation of the budget could be logically correct, but the relationship could be
misstated. For example, a person may state that credit sales are collected in the month following
the sales were actually credit customers pay their debt on or after 60 days credit period. Moreover,
relationships could be stated correctly, formulation of the budget could be logically correct but
things may not materialize as budgeted. For example, customers might take longer period than
expected to pay their bills; costs might be higher or lower than budgeted, and so on. However,
such type of deviations is tolerable and is considered as an input to modify or improve budgets. In
the following paragraphs each element of the master budget will be discussed item- by-item.

a) Sales Budget
The preparation of master budget begins with the sales budget because the sales budget is the basis
for all other budgets. It is from sales budget that budgets for purchases, manufacturing costs,
selling and administrative expenses, cash, and other budgets are prepared, and enable us to prepare
pro-forma financial statements - budgeted income statement and budgeted balance sheet. Sales
budget is a formal plan that set forth a firm’s anticipated sales in units and in monetary figures for
the budget period.

Methods used in forecasting sales vary widely from firm to firm. Each firm has specific
characteristic, which influence the method to be employed. The method (technique) could vary
from simple estimates based on past experience to sophisticated statistical approaches and
computer models. Whichever method is used, some prediction must be made concerning how
many units of each product can be sold and at what unit-selling price for the budget period. Some
of the inputs for sales forecasting are discussed in the following paragraphs.
Past pattern of sales - Sales from past periods can be broken down by product lines, regions
and sales people to provide a basis for estimating possible future sales.
Estimates made by sales men - Since sales force has close relation (contact) to the customers
and sales activity, they may have reasonable estimate for the budget period. The sales person
prepares sales estimates for the budget period in light of his knowledge of the past and his
expectations for the future.
General economic conditions and competitive conditions - The higher level management who
are better informed with respect to the total economic picture consider these inputs in the estimates
made by sales men. The general price level, the state of inflation and other
Economic conditions like boom, recoveries, etc. are considered in developing the final sales
forecast.
Results of market researches - The results of market survey help managers in determining the
potential demand available and the market capacity. Market studies show customer preference for
a particular product and may reveal which product is more attractive than the other.
 Other factors such as advertising and promotion budgets, change in prices and specific
interrelationships of sales and economic indicators such as gross domestic product (GDP) and
industrial price indexes are important input factors in sales forecasting.

Illustration
Royal Company is preparing budgets for the quarter ending June 30, 2013. Budgeted sales for the
next five months are given below. The selling price is $10 per unit.
Months April May June July August
Sales in units 20,000 50,000 30,000 25,000 15,000

The extent to which the company can realize its goal of balanced production depends on the time
required to produce a unit of one product as compared with another, the sales volume of each
product line, the labor and facilities required in production and other factors related to the
peculiarities of the products themselves.

To produce the sales budget prices established for various product lines are applied to the sales
budget in units of product. If price changes are expected during the fiscal period then the budget
should be altered accordingly. Royal Company plans to sell its product at uniform price
throughout the quarter period. The Product sells at $10 a unit. The unit price is multiplied by total
units to sell during each month to develop the sales budget in monetary terms. Therefore, the sales
budget for the quarter period ended June 30, 2013 would be:
Royal Company Gross Sales Revenue Budget
For the Quarter ended June 30, 2013

April May June Total

Budgeted Sales in units 20,000 50,000 30,000 100,000
Selling price per unit X $10 X $10 X $10 X $10
Total Sales $200,000 $500,000 $300,000 $1,000,000

Sales and Production

The sales budget is the foundation for the production budget in manufacturing enterprises. It is
from the sales budget that the plans for manufacturing products that will be needed. In making its
plans, the manufacturing unit will schedule production so as to deliver products to be sold to
customers promptly. Therefore, the production plans will have to be synchronized with the sales
Budget. Otherwise, there may be excessive production or loss of sales due to under production
which, in both directions, affects adversely the firm.

From the other side, the sales unit will be limited in its planning by the capabilities and the
capacity of the manufacturing unit. It may be possible to sell a particular product but perhaps it
cannot be produced at a reasonable cost. The production unit (department) may have limited
capacity to produce a particular product even though the cost is reasonable to produce it. The firm
will then have to abandon prospects for sales. Sometimes, a firm may receive a special order with
specific standards from a customer. In such cases sales and production departments should join
and discuss on the issue whether to accept the order or not. The sales amount could be so attractive
but the production may not be effected under stringent standard specified by a customer. Sales
estimates must also be tied in with manufacturing capacity. It may be possible to sell more than the
firm can normally produce. However, at some point a maximum limit of production will be
reached and the firm will be forced to add its productive capacity if it expects to increase sales
volume. Sales and production must be coordinated closely. Neither function can be planned nor
can budgets for each be prepared in isolation. The sale depends on the capacity of manufacturing
(production) departments and the production is guided by the sales estimates.

b) The Production Budget

The production budget stems from the sales budget. Once the sales forecast and the sales budget
are completed, the next phase in developing the master budget is to prepare the production budget.
The production budget is a formal plan quantifying in units the required production for the budget
period based on sales budget and the policy of the firm on finished goods inventories. If products
are relatively perishable or if they cannot be stored, they will have to be produced at about the time
they are to be sold. On the other hand, if the products can be stored, the production schedule can
be more flexible in accordance to the policy of the firm.

Production budget is governed by the firm’s inventory policy. Inventories may be built up or
liquidated depending upon the policy adopted by management and the outlook for future sales. The
sales budget, on a unit basis related to the desired inventory level, can be converted into a budget
of units to be produced.

To illustrate, in the budget of Royal Company, sales and production for the quarter period is the
same, although there are variations within the period from month to month. These seasonal
variations complement each other and the company uses the plant evenly throughout with few
variations. The inventory policy of Royal Company is to have a minimum of 20% of the following
month’s budgeted sales in units. The inventories of finished goods balances on hand on March 31,
2013, were 4,000 units. Therefore, the ending finished goods inventory balance in units during the
budget period is computed as follows:
Inventories of finished goods balance on:
April 30, 2013 = 20% of May budgeted sales in units = 0.2 x 50,000 = 10,000 units
May 31, 2013 = 20% of June budgeted sales in units = 0.2 x 30,000 = 6,000 units
June 30, 2013 = 20% of July budgeted sales in units = 0.2 x 25,000 = 5,000 units

Therefore, we can determine the inventories of finished goods balance at the beginning of each
month as follow:
Inventories of finished goods balance on:
March 31, 2013 = April 1, 2013 = 4,000 units
April 30, 2013 = May 1, 2013 = 10,000 units
May 31, 2013 = June 1, 2013 = 6,000 units
June 30, 2013 = July 1, 2013 = 5,000 units

The above calculations of opening and closing of each month's inventories of finished goods
balance could be summarized in the following table:
Month Sales in units Beginning Inv. in units Ending Inv. in units
March - - 4,000
April 20,000 4,000 10,000
May 50,000 10,000 6,000
June 30,000 6,000 5,000
July 25,000 5,000 3,000

Required production formula in units:

Required = Budgeted + Desired Ending - Beginning Finished

Production Units Sales Units Finished Goods Units Goods Units

Using the above inputs and required production (in units) formula, the production budget for
Royal Company during the budget period is:

Royal Company Production Budget in Units

For the Quarter ended June 30, 2013

April May June Total

Budgeted Sales in units 20,000 50,000 30,000 100,000
Add: Desired Ending Inv. 10,000 6,000 5,000 5,000
Total Needed 30,000 56,000 35,000 105,000
Less: Beginning Inv. (4,000) (10,000) (6,000) (4,000)
Required production 26,000 46,000 29,000 101,000
 c) The Manufacturing Cost Budget
It is indicated in the earlier topics that the sales budget is the keystone for the master budget. The
production budget is the keystone for the manufacturing cost budget, which consists of direct
materials budget, direct labor budget, and manufacturing overhead budgets. After decision is
reached as to how many units should be produced, the manufacturing cost can be estimated.
Manufacturing cost is budgeted in the same way it is accounted for, by cost element. The
manufacturing cost budget is the summary of each manufacturing cost elements - direct materials,
direct labor, and manufacturing overhead costs.

i) The Direct Materials Budget

The production budget is the basis to develop the direct materials budget. The quantities of
materials that are required for manufacturing the products are estimated, with the estimate being
translated into materials usage budget for the budget period. The direct materials budget is a
formal plan indicating quantities and monetary amounts of direct materials purchases. Unless,
material purchases are planned in advance, it is very difficult to have smooth production for the
budget period. When direct materials budget is developed it is important to consider the inventory
policy of the organization. If materials can be stored, the purchases of raw materials may not
fluctuate with production. It may be possible to purchase materials in advance for favorable price.
It may be also possible to save by purchasing in large quantities.

However, savings obtained by purchasing under favorable conditions can be offset by more cost of
carrying excessive quantities of materials inventory. Therefore, a firm tries to seek a compromise
position, one in which neither the cost of purchasing nor the cost of storing an inventory is
excessive. The economic order quantity model helps much to compromise the carrying cost with
ordering costs.

Materials inventories, therefore, should be planned so that they vary only within maximum and
minimum established limits. These limits are required for all items in the inventory and set by
estimating how much is needed during the budget period. Careful estimates must be made how
many units of different types of materials are needed to make the various products. Standards are
usually used in such estimation with reasonable adjustments required. The materials usage budget
is the total materials required for production during the period. The material purchases budget is
derived from the usage budget and the minimum and maximum inventory limits. Purchases budget
is prepared in monetary terms. Therefore, unit costs are estimated and used in converting the
purchases budget into monetary figures. The monetary figures help for developing cash plan for
disbursements. The materials purchases budget is computed as follows:
Required materials for production in units (Usage Budget)
+ Required ending materials inventory in units
= Total materials needed in units
- Beginning materials inventory in units
= Budgeted materials purchases for the period in units

Required
Budgeted Materials Materials for Beginning
Purchases for the= Period Required Ending -Materials Inventory
Production +
Units Materials Inventory Units
Units
Units

The purchasing department is in the best position to provide data with respect to estimated costs
for materials. The department, by considering previous experience and the contacts it has with
different suppliers, can reasonably estimate the future costs of materials.

To illustrate, at Royal Company, five pounds (around 2.268kg) of material are required per unit of
product. Management wants materials on hand at the end of each month equal to 10% of the
following month’s production. On March 31, 2013, 13,000 pounds (lbs) of material are on hand.
Material cost $0.40 per pound.

Materials Inventories on:

April 30 = 10% of May production need = 0.1x230, 000 = 23,000 lbs May 31
= 10% of June production need = 0.1x145, 000 = 14,500 lbs June 30 = 10%
of July production need = 0.1x115, 000 = 11,500 lbs

Materials Inventories on:

March 31 = April 1 = 13,000 lbs
April 30 = May 1 = 23,000 lbs
May 31 = June 1 = 14,500 lbs

Now, let’s prepare the direct materials budget.

 Royal Company
Direct Materials Budget in Units and in Dollars For the Quarter
ended June 30, 2013
April May June Total
Budgeted production (units) 26,000 46,000 29,000 101,000
Materials per unit (lbs) x 5 x 5 x 5 x 5
Production Needed 130,000 230,000 145,000 505,000
Add: Desired Ending Inv. 23,000 14,500 11,500 11,500
Total Needed 153,000 244,500 156,500 516,500
Less: Beginning Inv. (13,000) (23,000) (14,500) (13,000)
Purchases to be made in units 140,000 221,500 142,000 503,500
Multiply by unit cost x$0.40 x$0.40 x$0.40 x$0.40
Total purchases budget in $ $56,000 $88,600 $56,800 $201,400

ii) The Direct Labor Budget

The direct labor budget is one of the major elements of manufacturing cost budget. It is developed
from the production budget. The direct labor budget is estimated first on a physical quantity basis.
The company should know in advance whether sufficient labor time is available to meet the
production needs. There is no inventory planning problem in developing the direct labor budget.
But there are other problems such as training existing employees or hiring new qualified persons.
For example, the production budget may call for special training of employees, and accordingly
training should take place in advance so as to make them ready before actual participation in the
production process. Probably, the need for qualified personnel may be for limited period of time
and may prove that improper investment is made on training employees since the anticipated
increases in production are not permanent.
The labor time required to manufacture products can be estimated from standards or from records
of past performance with some adjustments. To prepare the direct labor cost budget, total labor
hours are broken down by pay classification.
In our example above for Royal Company, direct labor budget developed is based on past
experience. Working conditions and facilities don’t change in the budget period.
• At Royal, each unit of product requires 0.05 hours (3 minutes) of direct labor.
• The Company has a “no layoff” policy so all employees will be paid for 40 hours of work
each week.
• In exchange for the “no layoff” policy, workers agreed to a wage rate of $10 per hour
regardless of the hours worked (Overtime paid as straight time).
• For the next three months, the direct labor workforce will be paid for a minimum of 1,500
hours per month.

Now, let’s prepare the direct labor budget.

.
 Royal Company
Direct Labor Budget (in hrs& $) For the Quarter ended
June 30,2013
April May June Total
Budgeted Production in units 26,000 46,000 29,000 101,000
Direct labor hours x 0.05 x 0.05 x 0.05 x 0.05
Labor hours required 1,300 2,300 1,450 5,050
Guaranteed labor hours 1,500 1,500 1,500
Labor hours paid 1,500 2,300 1,500 5,300
Multiplied by Wage rate x $10 x $10 x $10 x $10
Total Direct labor Cost $15,000 $23,000 $15,000 $53,000

Higher of labor hours required or labor hours guaranteed.

iii) The Manufacturing Overhead Budget

The manufacturing overhead budget deserves a considerable attention since it includes all
production costs except the direct material and the direct labor costs. It should provide schedules
of all costs included in it. Therefore, individual cost classifications are examined closely to see
how each cost behaves when there is a change in volume of production or in relation to other
factors.

The basic grouping process of manufacturing overhead costs is to identify costs as variable and
fixed. For variable overhead costs, the cost per selected cost driver should be estimated and used to
develop the total budget. The budget for fixed manufacturing overhead cost is determined by
considering past data and any proposed change on these cost elements. If a firm, for example,
planned to acquire a new machine to increase production, this additional investment on fixed
facility should be added to previous fixed costs to get the new fixed cost budget.

For Royal Company, the following items are part of the manufacturing overhead costs categorized
as variable and fixed cost elements.
- Variable manufacturing overhead costs:
 Factory supplies (including indirect materials)
 Factory power, heat and light
 Repair and maintenance
- Fixed manufacturing overhead costs
 Factory supervision,  Factory power, heat and light
 Indirect labor,  Repair and maintenance
 Taxes and Insurance on factory  Depreciation
properties
The variable manufacturing overhead costs vary with volume of outputs. Royal Company uses a
variable manufacturing overhead rate of $1 per unit produced. And fixed manufacturing overhead
is $50,000 per month and includes $20,000 of noncash costs (primarily depreciation of plant
assets).

Now, let’s prepare the manufacturing overhead budget.

Royal Company Manufacturing Overhead Budget
For the Quarter ended June 30, 2013

April May June Total

Budgeted production (units) 26,000 46,000 29,000 101,000
Multiply by Variable mfg OH rate x $1 x $1 x $1 x $1
Variable mfg OH Costs $26,000 $46,000 $29,000 $101,000
Add: Fixed mfg OH Costs $50,000 $50,000 $50,000 $150,000
$76,000 $96,000 $79,000 $251,000
Total mfg OH Costs
Less: Noncash costs (20,000) (20,000) (20,000) (60,000)
Cash Disbursements for MOH $56,000 $76,000 $59,000 $191,000

Depreciation is a noncash charge.

d) Ending Finished Goods Inventory Budget

• Now, Royal can complete the ending finished goods inventory budget.
• At Royal, manufacturing overhead is applied to units of product on the basis of direct
labor hours.

Now, let’s calculate ending finished goods inventory.

Production costs per unit Quantity Cost Total
Direct materials 5.00 lbs. $ 0.40 $ 2.00
Direct labor 0.05 hrs. $10.00 0.50
Manufacturing overhead 0.05 hrs. $49.70 2.49
Unit product cost $ 4.99

Budgeted finished goods inventory

Ending inventory in units 5,000
Unit product cost $ 4.99
Ending finished goods inventory $24,950

From Direct materials budget and information

From Direct labor budget

From OH budget Predetermined Overhead Rate:

= Total mfg. OHforquarter= $251,000
Total laborhoursrequired5,050hrs.= $49.70 per hr(rounded)
 e) Selling and Administrative Costs Budget
This budget is composed two budgets - selling expenses and administrative expenses - usually
called the non-manufacturing costs budget.

The Selling Expenses Budget

To be more efficient in accounting for costs, a firm needs to plan for costs other than
manufacturing costs. The selling expense budget is quantitative listings of each planned selling
costs for the budget period. This budget includes the cost of promoting, marketing and distributing
products in the budget period.

The General and Administrative Expenses Budget

The general and administrative expenses budget is constructed in the same way as the selling
expenses budget is developed. It is list of each planned general and administrative expenses for the
budget period. These expenses are costs of administration and costs of maintaining the firm as an
economic entity. They are usually fixed in nature and have less direct relationship to sales.
However, in the long run, they are dependent upon sales volume. The general and administrative
expenses are also broken-down in different parts for control purpose.

Both Selling expenses and administrative expenses can be divided as variable and fixed expenses.
i.e., identification of cost behavior helps much in developing the budget. For brevity, selling
expenses and administrative expenses budgets for Royal Company are combined into a single
schedule.
• At Royal, variable selling and administrative expenses are $0.50 per units old.
• Fixed selling and administrative expenses are $70,000 per month.
• The fixed selling and administrative expenses include $10,000 in costs – primarily
depreciation – that are not cash outflows of the current month.

Now, let’s prepare the company’s selling and administrative expense budget.
Royal Company
Selling and Administrative Expense Budget For the Quarter ended June
30, 2013
April May June Quarter
Budgeted sales in units 20,000 50,000 30,000 100,000
Variable S&A rate x$0.50 x$ 0.50 x$0.50 x$ 0.50
Variable S&A expense $10,000 $25,000 $15,000 $ 50,000
Fixed S&A expense 70,000 70,000 70,000 210,000
Total S&A expense $80,000 $95,000 $85,000 $260,000
Less: noncash expenses (10,000) (10,000) (10,000) (30,000)
Cash disbursements for S&A $70,000 $85,000 $75,000 $230,000
The Capital Budget
Capital budgeting is making of long-term planning decisions for investments. Plan for the
acquisition of various properties such as buildings, machinery, equipment, and other long-term
investment is referred as the capital budget or capital expenditure budget. The topic capital
budgeting is discussed in more details in financial management course. Each year or quarter a
provision must be made in the current annual or quarterly budget for the portion of the long-term
plan to be carried out during the budget period. For instance, Royal plan to purchase $143,700 of
equipment in May and $48,300 in June paid in cash.

f) The Cash Budget

The cash budget is a schedule of expected cash receipts and disbursements. It is broken down into
sections that show cash receipts, cash disbursements, cash surplus or deficiency and financing
activities.

The Cash Receipts Budget

Cash can be collected (received) from operating activities and from other sources such as grants,
borrowings, etc. Normally the sales activity is expected to produce the bulk of the cash receipts. If
sales are made on credit basis, the time period within which customers do pay should be estimated
and cash collection from credit customers is determined. How long the accounts receivable
remains outstanding depends on the credit policy of the firm under consideration. From the study
of past records and recent experience in the rate of collection, it should be possible to predict
approximate receipts on account. The collection pattern for Royal Company is as follows:
all sales are on account.
 Royal’s collection pattern is:
»70% collected in the month of sale,
»25% collected in the month following sale,
»5% is uncollectible.
 The March 31 accounts receivable balance of $30,000 will be collected in full.

Now, let's prepare the cash collection budget for Royal:

 Royal Company Cash Receipts Budget
For the Quarter ended June 30, 2013

April May June Quarter

Sales $200,000 $ 500,000 $ 300,000

$ 30,000
Accounts Receivable, March 31 $ 30,000
April Sales
x 70% $140,000 140,000
x 25% $ 50,000 50,000
May Sales
x 70% 350,000 350,000
x 25% $ 125,000 125,000
June Sales
x 70% 210,000 210,000
Total Cash Collections $170,000 $ 400,000 $ 335,000 $ 905,000

The Cash Payments (Disbursements) Budget

Cash is paid for different purposes. To list few, cash is paid for capital acquisitions, settlement of
debts, for operating expense, etc. If at all possible, any firm prefers payments to be made at
convenient times, that is, when cash is excessively available. However, this is not possible because
demand for cash do not coincide with availability of excessive cash. In some months, several
payments could be made and in some other months few cash payment could be required.
Therefore, planning in advance how much cash is required during the period helps to identify
possible sources of financing in case of cash shortage and identify possible uses of cash in case of
excess cash.

Disbursements are not always made at the time that cost is incurred. For example, costs on
insurance and advertisement are paid in advance. Acquisition of raw materials could be made on
credit basis. On the other hand, payments for labor (wages), supplies and other expenses are
usually paid in the month they are incurred. Thus, a budget of cash payment is made by scheduling
payments that must be made for materials, labor, debt services, other operating costs (fixed and
variables) and so forth.

Royal Company developed the following cash disbursement scheme for materials which
necessitate cash payments during the budget period.
 Royal pays $0.40 per pound for its materials.
 One-half of a month’s purchases are paid for in the month of purchase; the other half is paid in
the following month.
 The March 31 accounts payable balance is $12,000.
Now, let’s calculate expected cash disbursements for Royal.

Royal Company
Cash Disbursements Budget
For the Quarter ended June 30, 2013
April May June Quarter
Purchases $56,000 $88,600 $56,800
Accounts Payable March 31 $ 12,000 $ 12,000
April Purchases
$56,000 x 50% 28,000 28,000
$56,000 x 50% $ 28,000 28,000
May Purchases
$88,600 x 50% 44,300 44,300
$88,600 x 50% $44,300 44,300
June Purchases
$56,800 x 50% 28,400 28,400
Total Cash Disbursements $ 40,000 $ 72,300 $72,700 $ 185,000

The budgeted cash receipts and disbursements are combined together to form a summary of cash
budget. On the summary of cash budget, cash surplus or deficiency and financing activities are
shown. To determine the surplus or deficiency and see financing activities, the financial policy of a
firm should be known. Some firms like to maintain relatively large amount of cash while others
prefer to have moderate amount of cash. Maintaining very high or very low cash balance is risky.
Therefore, firms establish a minimum cash balance and the surplus would be invested to earn a
profit and the deficiency should be financed.

The management of Royal Company for instance, believes that it can compete more successfully
and obtain larger orders from existing customers and potential customers with a large volume and
anticipated that sufficient cash should be available whenever needed. Anticipating large cash
balance, management plans to have a cash balance at the end of each month to be $30,000. If there
is excess cash it will be kept on hand for any need and if there is deficiency it could be financed
from open line of credit.

The total outflow and inflow of cash is dependent on other activities. When disbursements are
estimated, the detailed component of the total disbursements should be analyzed so as to minimize
credits and hence less interest would be paid. If cash budget shows excess cash, it should be
invested, because keeping idle cash is a cost by itself.

Royal Company developed the following summary of cash collections and cash disbursement
scheme for all items during the budget period.
 maintains a 16% open line of credit for $75,000.
 maintains a minimum cash balance of $30,000.
 Borrows on the first day of the month and repays loans on the last day of the month.
 pays a cash dividend of $49,000 in April.
 Purchases $143,700 of equipment in May and $48,300 in June paid in cash.
 has an April 1 cash balance of $40,000.
All wages and salaries are paid at the end of each month. Thus, no accrued wage and salaries are
expected during the budget period.
All other expenses are paid in the month they are incurred.
Royal Company Summary Cash Budget
For the Quarter ended June 30, 2013

April May June Quarter

Beginning cash balance $ 40,000 $ 30,000 $ 30,000 $ 40,000
Add: cash collections 170,000 400,000 335,000 905,000
Total cash available 210,000 430,000 365,000 945,000
Less: disbursements:
Materials 40,000 72,300 72,700 185,000
Direct labor 15,000 23,000 15,000 53,000
Mfg overhead 56,000 76,000 59,000 191,000
Selling and admin. 70,000 85,000 75,000 230,000
Equipment purchase - 143,700 48,300 192,000
Dividends 49,000 - - 49,000
Total disbursements 230,000 400,000 270,000 900,000
Excess (deficiency) $ (20,000) $ 30,000 $ 95,000 $ 45,000
Financing:
Borrowing 50,000 - - 50,000

Repayments - - (50,000) (50,000)

Interest - - (2,000) (2,000)

Total financing 50,000 - (52,000) (2,000)
Ending cash balance $ 30,000 $ 30,000 $ 43,000 $ 43,000

g) The Budgeted Income Statement

The budgeted income statement is a projected income statement based on the various units of the
operating budgets and the cash budget for interest income or interest expense. It is a summary of
the expected results and shows whether or not profit plans, as reflected in the budgets, can be
realized by bringing together the various revenue and expense budgets and making it more easier
to evaluate the overall operation of the firm for the budget period.
The budgeted income statement for Royal Company is prepared from revenue and cost budgets.

Royal Company Budgeted Income Statement

For the Quarter ended June 30, 2013

April May June Quarter

Sales (units @ $10) $200,000 $500,000 $300,000 $ 1,000,000
Less: CGS (units @ $4.99) 99,800 249,500 149,700 499,000
Gross Margin $ 100,200 $250,500 $150,300 $ 501,000
Less: S&A Expenses 80,000 95,000 85,000 260,000
Operating Income $20,200 $155,500 $ 65,300 $ 241,000
Less: Interest Expense 0 0 2,000 2,000
Net Income $20,200 $155,500 $ 63,300 $239,000

h) The Budgeted Balance Sheet

The budgeted balance sheet is estimated or pro forma balance sheet which indicates the budgeted
financial position for some later date. It is a projected statement of financial position that reflects
the expected balances in the accounts at the end of the planning period. Like the estimated income
statements it is a summary budget statement that depends upon the various individual budgets
which have been prepared. The budgeted balance sheet preparation starts from the beginning
balance sheet and adjust figures for expected changes as per the operating and cash budgets. It can
be compared with historical statements to show how assets and equities are affected by operation
during the budget period. The comparison of the budgeted balance sheet with historical one helps
not only to see the effects of operation on balance sheet items but also pin point areas of trouble in
advance and urge managers to take remedial actions.

Royal reported the following account balances on March 31 prior to preparing its budgeted
financial statements:
 Land = $50,000
 Building (net) = $175,000
 Common stock = $200,000
 Retained earnings = $146,150

Following account balances are determined from the master budget:

 Accounts Receivable = 25% of June Sales = 0.25 x $300,000 = $75,000
 Raw Materials Inventory = 11,500 lbs @ $0.40/lb = $4,600
 Finished Goods Inventory = 5,000 units @ $4.99 each = $24,950
 Accounts Payable = 50% of June purchases = 0.5 x $56,800 = $28,400
 Retained Earnings:
Beginning balance $ 146,150
Add: net income 239,000
Deduct: dividends (49,000)
Ending balance $ 336,150

Hence, budgeted balance sheet for Royal Company is as follows:

Royal Company Budgeted Balance Sheet

For the Quarter ended June 30, 2013

March 31
Current Assets
Cash $ 43,000 $xxx
Accounts Receivable 75,000 Xxx
Raw Materials Inventory 4,600 Xxx
Finished Goods Inventory 24,950 Xxx
Total Current Assets $147,550 $xxx
Property and Equipment
Land $ 50,000 $xxx
Building 175,000 Xxx
Equipment 192,000 Xxx
Total Property and Equipment $417,000 $xxx
Total Assets $ 564,550 $xxx

Liabilities
Accounts Payable $ 28,400 $xxx
Shareholders' Equity
Common Stock $200,000 Xxx
Retained Earnings 336,150 Xxx

Total Liabilities & Equities $564,550 $xxx

3.5 Budgeting and Human Behavior

A budget can have a significant impact on human behavior. It may inspire a manager to higher
levels of performance. Or, it may discourage additional effort and pull down the morale of a
manager. Why do these diverse effects occur? The answer is found in how the budget is
Developed and administered. In developing the budget, each level of management should be
invited to participate. This “bottom-to-top” approach is referred to as participative budgeting.
The advantages of participative budgeting are, first, that lower-level managers have more detailed
knowledge of their specific area and thus are able to pro-vide more accurate budgetary estimates.
Second, when lower-level managers participate in the budgeting process, they are more likely to
perceive the resulting budget as fair. The overall goal is to reach agreement on a budget that the
managers consider fair and achievable, but which also meets the corporate goals set by top
management. When this goal is met, the budget will provide positive motivation for the managers.
In contrast, if the managers view the budget as being unfair and unrealistic, they may feel
discouraged and uncommitted to budget goals. The risk of having unrealistic budgets is generally
greater when the budget is developed from top management down to lower management than vice
versa.

Participative budgeting does, however, have potential disadvantages. First, it is more time-
consuming (and thus more costly) than a “top-down” approach, in which the budget is simply
dictated to lower-level managers. A second disadvantage is that participative budgeting can foster
budgetary “gaming” through budgetary slack. Budgetary slack occurs when managers
intentionally under-estimate budgeted revenues or overestimate budgeted expenses in order to
make it easier to achieve budgetary goals. To minimize budgetary slack, higher-level managers
must carefully review and thoroughly question the budget projections provided to them by
employees whom they supervise. The following exhibit graphically displays the appropriate flow
of budget data from bottom to top in an organization.

For the budget to be effective, top management must completely support the budget. The budget is
an important basis for evaluating performance. It also can be used as a positive aid in achieving
projected goals. The effect of an evaluation is positive when top management tempers criticism
with advice and assistance. In contrast, a manager is likely to respond negatively if top
Management uses the budget exclusively to assess blame. A budget should not be used as a
pressure device to force improved performance. In sum, a budget can be a manager’s friend or a
foe.
Ethics Note: Unrealistic budgets can lead to unethical employee behavior such as cutting corners
on the job or distorting internal financial reports.