BUDGETING

A budget is a quantitative expression of a plan of action prepared in advance

of the period to which it relates. Budget may be prepared for the business
as whole, for departments, for functions such as sales and production, for
financial and resource items such as cash, capital expenditure, manpower,
purchase etc.
The process of preparing and agreeing budgets is a means of translating the
overall objectives of the organization into detailed, feasible plans of actions.

The formal definition of budget is as follows: - A plan of action expressed in

form of money or units.
It is prepared and approved prior/before to the budget period and may show
income, expenditure, and the capital to be employed.

It may be drawn up showing incremental effects on former budget or actual

figures or be compiled by zero-based budgeting.

Budgeting is about making plans for the future, implementing those plans and
monitoring activities to see whether they conform to plan.

To do this successfully requires full top management support, cooperative

and motivated middle managers and staff, and well organized reporting
systems.

Budget may also be defined as a comprehensive and coordinated plan,

expressed in financial terms, for the operations, and resources of an
enterprise for some specified period in the future.
STEPS INVOLVED IN BUDGETING.
a) Objectives defined as a broad and long range desired state/position of
the firm/ communication of budgeting policies and guidelines to the
budgetees.
b) Goal / targets specified in quantitative terms to be achieved in a
specified period of time/ determination of the critical budget factor
c) Preparation of sales and other budgets
 d) Negotiation of budgets
e) Coordination of budgets
f) Strategies are set- this are specific methods/courses of action to
achieve the goals
g) Approval of budgets
h) Implementation and monitoring of results.

The essential elements of budget:-

a) Planning
b) Financial terms
c) Operations and resources
d) A specified future period
e) Comprehensiveness
f) Coordination

The main objective of budgeting:-

a. Explicit statement of expectations / planning
b. Communications
c. Coordination
d. Expectations as a framework for judging performance.

Comprehensive/master budget
The overall budget is known as the master budget.
It normally consists of two types of budgets:-
a) Operating budgets, sales, pdn, mate, labour
b) Cash budget

Operating budget relates to physical activities/operations of the firm such

as the sales, production, purchasing etc.
it also includes a budgeted income statement and a proforma balance sheet.

Cash budget is a statement showing the estimated cash inflows and outflows
over the cash planning horizon (period)
The sales budget acts as the key budget during preparation of all the other
operating budgets.

The Master Budget

◆ Set of interrelated budgets that constitutes a plan of action
for a specified time period.
◆ Contains two classes of budgets:
► Operating budgets.
Financial budgets.
Sales Budget
◆ First budget prepared.
◆ Derived from the sales forecast.
► Management’s best estimate of sales revenue for the
budget period.
◆ Every other budget depends on the sales budget.
◆ Prepared by multiplying expected unit sales volume for each
product times anticipated unit selling price.
Sales budget = units planned to be sold * planned unit selling price

Production budget

◆ Shows units that must be produced to meet anticipated sales.

◆ Derived from sales budget plus the desired change in ending
finished goods inventory.
◆ Essential to have a realistic estimate of ending inventory.

Direct Materials purchase Budget

◆ Shows both the quantity and cost of direct materials to be purchased.
◆ Formula for direct materials quantities.

◆ Budgeted cost of direct materials to be purchased = required

units of direct materials x anticipated cost per unit.
◆ Inadequate inventories could result in temporary shutdowns of
production.
Direct labour budget

◆ Shows both the quantity of hours and cost of direct labor

necessary to meet production requirements.
◆ Critical in maintaining a labor force that can meet expected
production.
◆ Total direct labor cost formula:

Manufacturing Overhead Budget

◆ Shows the expected manufacturing overhead costs for the budget period.
Distinguishes between fixed and variable overhead costs

Overhead budget
Controllable overheads Rate Amount
Mainternence
Power
Indirect wages
Total controllable overheads
Non controllable overheads
Depreciation
Power
Electricty
Total controllable overheads
Total overheads
Budgeted income statement
◆ Important end-product of the operating budgets.
◆ Indicates expected profitability of operations.
◆ Provides a basis for evaluating company performance.
◆ Prepared from the operating budgets:
► Sales
► Direct Materials
► Direct Labor
► Manufacturing Overhead
► Selling and Administrative Expense

Cash Budget
◆ Shows anticipated cash flows.
◆ Often considered to be the most important output in preparing financial
budgets.
◆ Contains three sections:
► Cash Receipts
► Cash Disbursements
► Financing
◆ Shows beginning and ending cash balances.
Receipts Year 1 /january/period 1 Year 2/ february/period 2
Cash sales xxx
Machine sold xxx
Dividends xxx
Receipts from debtors xx
Receipts from insurance xx
Total receipts xxxx
Less payments
Salaries
bbb
ccc
vvb
Total payments xxx
Excess /deficit xxx
Add opening balance xxx Xxxx
Closing balance xxxx xxxx

◆ Cash Receipts Section

► Expected receipts from the principal sources of revenue.
► Expected interest and dividends receipts, proceeds from
planned sales of investments, plant assets, and the
company’s capital stock.
◆ Cash Disbursements Section
► Expected cash payments for direct materials, direct labor,
manufacturing overhead, and selling and administrative
expenses.
◆ Financing Section
Expected borrowings and repayments of borrowed funds plus interest.

Cash Budget
◆ Must prepare in sequence.
◆ Ending cash balance of one period is the beginning cash balance
for the next.
◆ Data obtained from other budgets and from management.
◆ Often prepared for the year on a monthly basis.
◆ Contributes to more effective cash management.
◆ Shows managers the need for additional financing before actual
need arises.
◆ Indicates when excess cash will be available.
THE BENEFITIES OF BUGDETING:-
a) Planning and coordination:- this is facilitated by the preparation of
master budget which summarizes all the supporting budgets hence it
forces managers to think of the relationship of their function or
department with others and how they contribute to the achievement
of organizational objectives.
b) Clarification of authority and responsibility: - e.g. clarifying the
responsibilities of each manager who has a budget, subordinates are
given well defined roles and this is a good example of management by
exception in action.
c) Communication: - it includes all levels of management. It communicates
the agreed plans to all the staff involved, as well as vertical
communication, there must be full liaison between the sales and
production functions to ensure that coordinated budgets are
developed.
d) Control: - this is the process of comparing actual results with planned
results and reporting on the variations, which is the principle of
budgetary control, sets a control framework which helps expenditure
to be kept within agreed limits. Deviations are noted so that so that
corrective actions can be taken.
e) Motivation: - Due to involvement of both lower and middle management
in the preparation of budget acts as motivating factor.
f) Evaluating the performance of managers by assessing how well they
succeed in meeting the budgets, which they participated in
formulating.

PROBLEMS IN BUGDETING
a) It may be seen as pressure device especially when imposed by top
management hence this can lead to manipulation of results and poor
labour relations.
b) Dysfunctional decision-making when a manager attempts to improve
short term performance at the expense of long term performance of
the organization as whole.
c) Departmental conflicts may arise over resource allocation.
 d) Managers may build slack in their budget by overstating expenses and
understating income with intention of arriving at a budget which can
easily be achieved.
e) Waste or inefficient utilization of resources when the budget
allocations are used in order to ensure that next years allocation will
not be affected by under spending in the current period. This is
particularly common problem in the public sector.
f) Where incremental budgeting is used there is a danger of
incorporating past inefficiencies in the budgets.

ADMINISTRATION OF THE ANNUAL BUDGET

a) An organization should set up appropriate administrative procedures to

ensure that the budgeting process operates effectively. i.e. setting
the budget committee
b) A budget committee will consist of top management team and each
member representing the major segment of a department. Their major
task is to ensure satisfactory co-ordination of the budgets prepared
by departmental managers and that the budgets are realistic.
c) The functional heads presents their budgets to the budget committee
for review and approval.
d) The budget committee should appoint the budget officer, normally an
accountant, who is responsible for compiling the functional budgets
into a master budget for the organization.

- A budget manual is a document that is prepared by the budget officer,

describing the objectives and procedures involved in the budgeting
process, budgetary control reports and functions of the budget officer
and the budget committee. It also provides the time table for completion
of various budgets for review.

Forms/approaches of budgeting
a) Incremental budgeting
b) Zero – base budgeting (ZBB)
c) Fixed budgeting
 d) Flexible budgeting
e) Activity based budgeting (ABB)

Incremental budgeting
This is an approach which takes the current level of operating activity and
current budget allowances for existing activities as the starting point for
preparing the next year’s budget.

This base is adjusted for changes that are expected to occur during the
budget period.
It is known as incremental budgeting because budget process focus on
changes in operations or expenditure that is expected during the budget
period.
A major disadvantage of this approach is the danger of incorporating past
inefficiencies in the budgets.

Zero based budgeting

Is the budgeting approach which starts from base zero.
This approach requires justification of each program, both existing and new,
as if they were being launched for the first time.
Stages of zero based budgeting:-
Description of each activity in a decision packages
Evaluation and ranking of the decision package
Allocation of resources in line with the ranking

----------- Resources are allocated to the most critical packages first

Advantages of zero based budgeting

a) Effective utilization of resources since resource allocation is based on
need and benefit.
b) Creates questioning attitude rather than the one that assumes that
current practice represents value for money.
c) Leads increased participation with its possible effects on increased
motivation and increased interest in the job.
d) It focuses attention on outputs in relation to value of money.
Disadvantage of zero based budgeting.
a) It is costly and time consuming
b) There is a considerable management skill required in both drawing
decision packages and for the ranking process.
c) It may encourage the wrong impression that all decisions have to be
made in the budget.
d) ZBB is not always acceptable to staff or management or trade unions
who may prefer the cosy status quo and who see the detailed
examination of alternatives, costs and benefits rather than
quantitative benefits.
e) Subjective judgments e.g. due to political pressure.
f) It may emphasize short term benefits to the detrimental of longer
term ones which in the end may be more important.

NB: ZBB is particularly appropriate for non-profit making organizations

where quality of the service is all important.

Fixed budget
Is a budget which is not altered/changed when actual activity is different
from planned activity level.
Advantages of fixed budget
a) It is useful for planning and measuring effectiveness e.g. whether or
not plans have been achieved.

Disadvantages of fixed budget

a) It can’t be used to measure efficiency e.g. how well the inputs have
been used to produce output.

FLEXIBLE BUDGETS
Is a budget that has been adjusted to the actual level of activity in order to
facilitate comparison of actual performance with the budget at the same
level of activity. So as to be prepare a flexible budget it is important to
have a clear understanding of the behaviour of costs in relation to changes
in the level of activity.
Example
Mbeya Manufacturing company has the following budgeted data for its
product for the first quarter of 2012.
Tshs per unit
Selling price 3,500
Direct material 1,400
Direct labour 700
Variable factory overheads 250
Variable selling expenses 200
Fixed costs are budgeted at Tshs 4,000,000/= and the above budgeted data
are valid within a relevant range of 8,000 – 12,000 units. Budgeted level of
activity for the first quarter of 1997 is 10,000 units.
You are required to prepare
a) A fixed budget for the first quarter
b) Flexible budgets at 9,000 units and 12,000 units
c) Variance report assuming actual level of activity for the first quarter
was 9,000 units and that costs incurred were:
Tshs
Direct materials 13,000,000
Direct labour 6,200,000
Variable factory overheads 2,125,000
Variable selling expenses 2,000,000
Fixed costs 4,150,000
Sales revenues 32,000,000

ACTIVITY BASED BUDGETING (ABB) sometimes termed as activity cost

management it is a planning and control system which seeks to support the
objective of continuous improvement.

ABB recognizes that:

a) It is activities which drive costs and the aims are to control the
causes (drivers) of cost directly rather than the costs themselves.
 b) Not all activities add value so it essential to differential and examine
activities for their value-adding potential.
c) The majority of activities in a department are driven by demands and
decisions beyond the immediate control of the budget holder.
d) More immediate and relevant performance measures are required than
are found in conventional budgeting systems.

Possible problems with activity based analysis

It may not be always suitable for month to month monitoring because of
short term fluctuations.

CONTROL IN ORGANIZATIONS.
Control is the process of monitoring actual performance to ensure that
activities of the organization are in accordance with the approved plans and
that they contribute towards the achievement of set objectives.

Any control system consists of the following important activities.

a) Establishment of targets
b) Measuring actual results
c) Comparisons of actual results with targets
d) Investigation of reasons for deviations from targets; and
e) Taking appropriate action

When the budgets are used as a control tool the process is known as
budgetary control. This process requires that a budget is split into shorter
periods for control. Feedback to managers in the form of reports comparing
actual results with budget is prepared for these shorter periods.

Responsibility accounting system

Is an accounting system which accumulates revenue and costs by areas of
responsibility (i.e. responsibility centres) such that it is possible to assess
the performance achieved by managers to whom authority has been
delegated.
RESPONSIBILITY ACCOUNTING

I. CHARACTERISTICS OF RESPONSIBILITY ACCOUNTING

A. Definition.

- An accounting system that collects, summarizes, and reports accounting

data relating to the responsibilities of individual managers.

- An accounting system which tracks and reports cost, expenses, revenues,

and operational statistics by area of responsibility or organizational unit.

- The system provides information to evaluate each manager on revenue and

expense items over which that manager has primary control (authority to

influence).

- Some reports contain only those items that are controllable by the

responsibility manager.

- Some reports contain both controllable and uncontrollable items;

- in this case, controllable and uncontrollable]e items should be clearly

separated.

- The identification of controllable items is a fundamental task in

responsibility accounting and reporting.

B. Some Basic Requirements.

- To implement a responsibility accounting system, the business must be

organized so that responsibility is assignable to individual managers.

- The various managers and their lines of responsibility should be fully

defined.

- The organization chart is usually used as a basis for responsibility

reporting.
- If clear lines of responsibility cannot be determined, it is very doubtful

that responsibility accounting can be implemented effectively.

- While decision-making power may be delegated for many items, some

decisions (related to particular revenues, expenses, costs or actions) may

remain exclusively under the control of top management.

- several items will be directly traceable to a particular manager's area of

responsibility but not actually be controllable by that manager. (Items such

as property taxes.)

- Note: the controllability criterion is crucial to the content of performance

reports for each manager.

II. THE CONCEPT OF CONTROL.

A. Absolute Control.

- Theoretically, a manager should have absolute control over an item to be

held responsible for it.

- Absolute controllability is rare.

- Frequently, external or internal factors beyond a manager's control may

affect revenues or expenses under that manager's responsibility.

- The theoretical requirement regarding absolute control must often be

compromised, since some degree of noncontrollability usually exists.

- The manager is therefore usually held responsible for items over which

that manager has relative control.

B. Relative Control.

- Relative control means that the manager has control over most of the

factors that influence a given budget item.

- The use of relative control as a basis for evaluation may lead to some

motivational problems, since managers may be evaluated on results that may

not reflect the manager's efforts or decisions.

- Most budget plans assign control on a relative basis in order to develop and

use segmental budgets.

III. RESPONSIBILITY REPORTS.

A. Basic Features.

- A feature of a responsibility accounting system is the varying amount of

detail included in the reports issued to different levels of management.

- Although the amount of detail varies, reports issued under a responsibility

accounting system are interrelated.

- Totals from the report on one level of management are carried forward in

the report to the management level immediately above.

- Data is appropriately summarized, filtered, and/or condensed as

information flows upward to higher levels of management.

- Encourages or allows "management by exception."

- Two basic methods are applied to present revenue and expense data:

(1) Only those items over which a manager has direct control are included in

the responsibility report for that management level.

- Any revenue or expense that the manager cannot directly control are not

included.

(2) Include all revenue and expense items that can be traced directly or

allocated indirectly to a particular manager, whether or not they are

controllable.
- In this approach, care must taken to separate controllable from

noncontrollable items in order to differentiate those items for which a

manager can and should be held responsible.

B. Desired Features.

1. Timely

2. Issued Regularly

3. Format should be relatively simple and easy to read.

- Confusing terminology should be avoided.

- Results should be expressed in physical terms where appropriate, since

such figures may be more familiar and understandable to managers.

- To assist management in quickly spotting budget variances, both budgeted

and actual amounts should be reported.

- A budget variance is the difference between the budgeted and actual

amounts of an item.

- Because variances highlight areas which require investigation, they are

helpful in applying the management by exception principle.

- Reports often include both current and year-to-date analyses.

IV. RESPONSIBILITY REPORTS —

V. RESPONSIBILITY CENTERS.

A. Basic Concepts.

1. A Segment.

- is a fairly autonomous unit or division of a company defined according to

function or product line.

- Function: marketing, production, finance, etc.

- Product line: shoe department, electrical products, food division.

2. A Responsibility Center.

- is a segment of an organization for which a particular executive is

responsible.

- There are three types of responsibility centers:

(1) Expense (or cost) center.

(2) Profit center.

(3) Investment center.

4. Revenue centre

B. Expense (Cost) Centers.

- A responsibility center incurring only expense (cost) items and producing

no direct revenue from the sale of goods or services.

- Managers are held responsible only for specified expense items.

- The appropriate goal of an expense center is the long-run minimization of

expenses.

- Short-run minimization of expenses may not be appropriate.

C. Revenue Centers

- Managers are held responsible for revenues (sales) only.

- Managers of such centers also responsible for controlling expenses of unit

as well.

D. Profit Centers.

- A responsibility center having both revenues and expenses.

- The manager must be able to control both of these categories.

- Controllable profits of a segment are shown when expenses under a

manager's control are deducted from revenues under that manager's

control.

- An expense center can be converted into a profit center by the utilization

of transfer prices.

- i.e., via the use of transfer prices, "artificial revenues" can be generated

for an expense center as it charges other organizational units of the

company for its services or product.

E. Investment Centers.

1. Basic Characteristics.

- A responsibility center having revenues, expenses, and an appropriate

investment base.

- The manager in charge of an investment center is responsible for and has

sizable control over revenues, expenses, and the investment base.

- The two most common ways for evaluating the performance of such a

center are :

(1) ROI (return on investment.)

(2) Residual Income.

2. Determining the Investment Base to be used in ROI calculations.

- It is a tricky matter.

- Two key issues which must be resolved in determining the value of the

investment base are

(1) Which assets should be included, and

- Key question: are the included assets actual controlled by the division

managers?

(2) How those assets should be valued.

- Major alternative:

- Original Cost.

- Book Value (original cost less accumulated depreciation to date.)

- Replacement Cost.

- Note: which ever choices are applied, managers will be motivated in some

direction.

- Companies prefer to evaluate segments as investment centers because the

ROI criterion facilitates performance comparisons between segments.

There are three types of responsibility centres, namely:

a) Cost centres, where managers are responsible for costs which are
under their control. A manager of the cost centre has no control over
revenues and investments.
b) Profit centre, where managers have responsibility of both revenues
and costs, and is therefore evaluated based on the profit generated
by the centre
c) Investment centre managers have control over costs, revenue and
investments in assets of this unit of organization.

NB an important feature of responsibility accounting system is

controllability.

REVIEW QUESTIONS.
Question one.
The Bahari Company manufactures products, known as dari and dori. Dari is
produced in department 1 and dori in department 2. The following
information is available for 2021.
Standard material and labour costs Per unit is as follows.
Tshs
Material A 1.8
Material B 4
Direct labour 3

Overhead is recovered on a direct labour hour basis.

The standard material and labour usage per unit for each product is as
follows:-

Dari dori
Material A 10 8
Material B 5 9
Direct labour 10 15

The balance sheet for the previous year ending 2020 was as follows:
Non current assets Tshs Tshs Tshs
Land 42,500
Buildings and equipment 323,000
Less depreciation 63,750 259,250 301,750
Current assets
Stocks, finished goods 24,769
Stocks raw materials 47,300
Debtors 72,250
Cash 8,500
152,819
Less current liabilities
Creditors 62,200 90,619
Net assets 392,369
Presented by shareholders’ interest:
300,000 ordinary shares of shs 1 each 300,000
Reserves 92,369
392,369

Other relevant data is as follows for the year 1999:

Finished products
Dari Dori
planned sales (units) 8,500 1,600
Selling price per unit (shs) 100 140
Ending inventory required (units) 1,870 90
Beginning inventory (units) 170 85
Direct materials
Material A Material B
Beginning inventory (Units) 8,500 8,000
Ending inventory required (units) 10,200 1,700

Dari Dori
Budgeted variable overhead rates
per direct labour hour Tshs Tshs
Indirect materials 0.30 0.20
Indirect labour 0.30 0.30
Power (variable portion) 0.15 0.10
Maintenance (variable portion) 0.05 0.10

Budgeted fixed overhead:

Depreciation 25,000 20,000
Supervision 25,000 10,000
Power (fixed portion) 10,000 500
Maintenance (fixed portion) 11,400 799

Estimated non-manufacturing overheads:

Stationery etc. (administration) 1000

Sales salary 18,500

Office salary 7,000
Commissions 15,000
Car expenses (sales) 5,500
Advertising 20,000
Miscellaneous (office) 2000
69,000

Budgeted cash flows are as follows:

Period 1 Period 2 Period 3 Period 4
Shs Shs Shs Shs
Receipts from customers 250,000 300,000 280,000 246,250
Payments
Materials 100,000 120,000 110,000 136,996
Wages 100,000 110,000 120,000 161,547
Other costs and expenses 30,000 25,000 18,004 3,409

Prepare the following budgets for the year 2021

i. Sales budget
ii. Production budget
iii. Direct materials usage budget
iv. Direct materials purchase budget
v. Direct labour budget
vi. Factory overhead budget
vii. Selling and administration budget
viii. Cash budget
ix. Budgeted income statement
x. Budgeted statement of financial position.