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Assignment No.2 Budgeting
Use of Various Techniques of
BUDGET: A budget is a plan for the future. Hence, budgets are planning tools, and they are usually prepared prior to the start of the period being budgeted. However, the comparison of the budget to actual results provides valuable information about performance. Therefore, budgets are both planning tools and performance evaluation tools. Budgets are part of a company's long-range planning system. While some portions of a long-range plan are concerned with the organization in five to ten years, the budget is the short-range portion of the plan. The following figure 1.1 shows that how the budgetary process fits into an overall general framework of planning, decision-making and control. 1. Establish objectives 2. Identify potential courses of action (i.e. strategies) Long-term planning process
3. Evaluate alternative strategic options 4. Select alternative courses of action 5. Implement long-term plan in the form of the annual budget
Annual budgeting process
6. Monitor actual results 7. Respond to divergencies from plan Figure 1.1 The role of long-term planning and budgeting within the planning, decision-making and control process
A budget is a quantitative plan for the future that assists the organization in coordinating activities. All large organizations prepare budgets. Many organizations prepare detailed budgets that look one year ahead, and budgets that look further into the future that contain relatively less detail and more general strategic direction.
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MULTIPLE FUNCTIONS/USES OF BUDGETS: Budgets serve a number of useful purposes. They include: 1. planning annual operations; 2. coordinating the activities of the various parts of the organization and ensuring that the parts are in harmony with each other; 3. communicating plans to the various responsibility centre managers; 4. motivating managers to strive to achieve the organizational goals; 5. controlling activities; 6. evaluating the performance of managers.
Planning The budgeting process ensures that managers do plan for future operations, and that they consider how conditions in the next year might change and what steps they should take now to respond to these changed conditions. This process encourages managers to anticipate problems before they arise, and hasty decisions that are made on the spur of the moment, based on expediency rather than reasoned judgment will be minimized.
Coordination The budget serves as a vehicle through which the actions of the different parts of an organization can be brought together and reconciled into a common plan. Without any guidance, managers may each make their own decisions, believing that they are working in the best interests of the organization.
Communication Through the budget, top management communicates its expectations to lower level management, so that all members of the organization may understand these expectations and can coordinate their activities to attain them.
Motivation
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The budget can be a useful device for influencing managerial behavior and motivating managers to perform in line with the organizational objectives. A budget provides a standard that under certain circumstances, a manager may be motivated to strive to achieve.
Control A budget assists managers in managing and controlling the activities for which they are responsible. By comparing the actual results with the budgeted amounts for different categories of expenses, managers can ascertain which costs do not conform to the original plan and thus require their attention.
STAGES IN BUDGETING PROCESS: The important stages are as follows: 1. communicating details of budget policy and guidelines to those people responsible for the preparation of budgets; 2. determining the factor that restricts output; 3. preparation of the sales budget; 4. initial preparation of various budgets; 5. negotiation of budgets with superiors; 6. coordination and review of budgets; 7. final acceptance of budgets; 8. ongoing review of budgets.
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USES OF VARIOUS BUDGETING TECHNIQUES MASTER BUDGETING The most common budgeting technique is to create a master budget which is the overall collection of budgets for the operation of the organization. It consists of the budgets for sales, manufacturing costs (materials, labor, and overhead) or merchandise purchases, selling expenses, and general and administrative expenses. These budgets are fixed, static or expected budgets.
Sales budget The sales budget is the starting point in putting together a comprehensive budget for a business. It includes the number of units to be sold and the selling price per unit. It is important to agree to the sales budget first because many other budgets are based on this data. Although its components are simple, getting a management team to agree on the number of units to be sold and the selling price per unit, the two items needed to prepare the budget, is often difficult and time- consuming. The Pickup Trucks Company, which makes trucks, has just completed its budgeting process for next year. Total expected sales are 100,000 trucks at a price of Rs.15.00 each. Its sales budget has been prepared on a quarterly basis as follows: The Pickup Trucks Company Sales Budget For the Year Ended December 31, 20X1 Quarter 1 Units
15,000
Selling Price Rs.15 Total Sales
Quarter 2
Quarter 3
Quarter 4
Total
17,000
28,000
40,000
100,000
Rs.15
Rs.15
Rs.15
Rs.15
Rs.225,000 Rs.255,000 Rs.420,000 Rs.600,000 Rs.1,500,000
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In addition to annual and quarterly sales budgets, monthly budgets are often prepared so sales can be tracked against expectations more frequently than once every three months.
Manufacturing costs Before preparing the direct materials, direct labor, and manufacturing overhead budgets, the production budget must be completed. Production budget. The production budget shows the number of units that must be produced. To budget for annual production, three things must be known: the number of units to be sold, the required level of inventory at the end of the year, and the number of units, if any, in the beginning inventory. If quarterly budgets are required, this same information is needed on a quarterly basis. Using the Pickup Trucks Company's quarterly sales budget and given that 15% of the next quarter's sales volume must be on hand before the quarter begins, the production budget by quarter can be prepared. Further assumptions are a 10% increase in sales in quarter one of next year compared to the current year's quarter-one sales and 2,250 units in inventory at the beginning of the year. Pickup Trucks Company Production Budget in Units for 20X1 Sales
15,000 17,000 28,000 40,000 100,000
Required Ending Inventory 2,550
4,200
6,000
2,475
2,475
Units Required
17,550 21,200 34,000 42,475 102,475
Beginning Inventory
(2,250) (2,550) (4,200) (6,000) (2,250)
Units to be Produced
15,300 18,650 29,800 36,475 100,225
Direct materials budget. The direct materials budget determines the number of units of raw materials to be purchased. It uses the number of units to be produced from the production budget, the required level of ending inventory for raw materials, and the number of units in beginning inventory. Once the number of units to be purchased is determined, it is multiplied by the cost per unit to determine the budgeted amount for raw materials purchases. The Pickup Trucks Company requires 10% of next quarter's production requirement for raw materials to be in its ending inventory. For example, because it takes five tires to make the special pickup truck (four Page 5 of 14
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plus the spare tire mounted on the side), at a cost of Rs.0.50 per tire, the raw materials purchases budget calculates 501,890 tires required at a cost of Rs.250,945. The units in the production budget are adjusted for units in ending and beginning inventories, multiplied by five (number of tires per pick up) to determine total tires to be purchased and then multiplied by Rs.0.50 to determine the cost of the tires needed. As a reminder, the production budget showed the following units for 20X1: Units Quarter 1
15,300
Quarter 2
18,650
Quarter 3
29,800
Quarter 4
36,475
Total
100,22 5 Pickup Trucks Company Raw Materials Budget For the Year 20X1 Quarter 1
Quarter 2 Quarter 3 Quarter 4
Total
Units to be produced
15,300
18,650
29,800
36,475
100,225
Number of tires per unit
×5
×5
×5
×5
×5
76,500
93,250
149,000
182,375
501,125
Required ending inventory
9,325
14,900
18,238
8,415
8,415
Total units required
85,825
108,150
167,238
190,790
509,540
Beginning inventory
(7,650)
(9,325)
(14,900)
(18,238)
(7,650)
Units to purchase
78,175
98,825
152,338
172,552
501,890
Cost per unit
× Rs.0.15
× Rs.0.15
× Rs.0.15
× Rs.0.15
× Rs.0.15
Cost of raw materials purchases
Rs.11,726
Rs. 14,824 Rs. 22,851 Rs. 25,883 Rs. 75,284
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This process is repeated for all the other raw material components used in producing a pickup truck. Direct labor budget. The direct labor budget shows the number of direct labor hours and the cost of the labor to determine the total cost of direct labor. Assume it takes one-half hour of labor to put together one pickup truck and each labor hour costs Rs.14.00. The total direct labor budget is for 50,113 (100,225 units × .5 hours per unit) hours at a cost of Rs.701,575 (Rs.14.00 per hour × 50,113 hours). The break out by quarter is shown in the following table. Pickup Trucks Company Direct Labor Budget For the Year 20X1 Quarter 1
Quarter 2
Quarter 3
Quarter 4
Total
15,300
18,650
29,800
36,475
100,225
Direct labor hours × .5 per unit
× .5
× .5
× .5
× .5
9,325
14,900
18,237.5
50,112.5
× Rs.14.00
× Rs.14.00
× Rs.14.00
× Rs.14.00
Rs.130,550
Rs.208,600
Rs.255,325
Rs.701,575
Units to be produced
Total direct labor hours
7,650
Cost per hour
× Rs.14.00
Cost of direct labor
Rs.107,100
Manufacturing overhead. The manufacturing overhead budget identifies the expected variable and fixed overhead costs for the year (or other period) being budgeted. The separation between fixed and variable costs is important because the Pickup Trucks Company uses a predetermined overhead rate for applying overhead to units produced. In preparing its budget, the Pickup Trucks Company has identified the following variable and fixed costs: indirect materials Rs.0.50 per unit, indirect labor Rs.1.00 per unit, maintenance Rs.0.75 per unit, annual depreciation Rs.12,000, supervisory salaries Rs.24,000, and property taxes and insurance Rs.21,000. The budget by quarter is: Pickup Trucks Company Manufacturing Overhead Budget For the Year 20X1
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Quarter 1 Quarter 2 Quarter 3 Quarter 4
Total
Variable Costs Indirect Materials
Rs.7,650
Indirect Labor
15,300
18,650
29,800
36,475
100,225
Maintenance
11,475
13,988
22,350
27,356
75,169
34,425
41,963
67,050
82,069
225,507
3,000
3,000
3,000
5,700
14,700
6,000
6,000
6,000
6,000
24,000
5,250
5,250
5,250
5,250
21,000
14,250
14,250
14,250
16,950
59,700
Total Variable Costs
Rs.9,325
Rs14,900 Rs.18,238 Rs.50,113
Fixed Costs Supervisory Salaries Property Taxes and Insurance Depreciation Total Fixed Costs Total Manufacturing Overhead
Rs.48,675 Rs.56,213 Rs.81,300 Rs.99,019 Rs.285,207
Total Direct Labor Hours
7,650
9,325
Predetermined Overhead Rate
14,900
18,238
50,113 Rs.5.70
Selling expenses budget The budget for selling expenses includes the variable and fixed selling expenses. The variable expenses in the selling expenses budget are usually based on sales dollars. Assume the Pickup Trucks Company's variable expenses are sales commissions and delivery expense. Sales commissions are 4% of sales dollars, and delivery expense, also called freight out by some companies, is Rs.0.10 per unit sold. The company also has fixed sales salaries of Rs.50,000. The calculations for sales commissions and delivery expense, followed by the selling expenses budget, are shown in the following tables. Pickup Trucks Company Sales Commission and Delivery Expenses Budget Calculations For the Year 20X1
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Sales Commission Expense Sales
Rs.225,000 Rs.255,000 Rs.420,000 Rs.600,000 Rs.1,500,000
Commission Rate
4%
Sales Commissions
Rs.9,000
4%
4%
4%
4%
Rs.10,200
Rs.16,800
Rs.24,000
Rs.60,000
Delivery Expense Units Sold
15,000
17,000
28,000
40,000
100,000
Cost per Unit
Rs.0.10
Rs.0.10
Rs.0.10
Rs.0.10
Rs.0.10
Delivery Expense Rs. 1,500 Rs. 1,700 Rs. 2,800 Rs. 4,000 Pickup Trucks Company Selling Expenses Budget For the Year 20X1
Rs.10,000
Variable Expenses Sales Commissions
Rs. 9,000 Rs.10,200 Rs.16,800 Rs.24,000 Rs. 60,000
Delivery Expense
1,500
Total Variable Expenses 10,500
1,700
2,800
4,000
10,000
11,900
19,600
28,000
70,000
12,500
12,500
12,500
50,000
Fixed Expenses Sales Salaries
12,500
Total Selling Expenses
Rs.23,000 Rs.24,400 Rs.32,100 Rs.40,500 Rs.120,000
General and administrative expenses budget The general and administrative expenses budget details the variable and fixed operating expenses for the general and administrative areas of the company. The Pickup Trucks Company has no variable administrative expenses. Its fixed expenses include salaries of Rs.60,000, rent expense of Rs.15,000, and office supplies of Rs.6,000. Pickup Trucks Company General and Administrative Expenses Budget For the Year 20X1
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Variable Expenses None Fixed Expenses Salaries
Rs.15,000 Rs.15,000 Rs.15,000 Rs.15,000 Rs.60,000
Rent Expense
3,750
3,750
3,750
3,750
15,000
Office Supplies
1,500
1,500
1,500
1,500
6,000
Total General and Administrative Expenses
Rs.20,250 Rs.20,250 Rs.20,250 Rs.20,250 Rs.81,000
Budgeted Income Statement The budgeted or budgeted income statement is prepared after the operating budgets have been completed. The cost of goods sold on the income statement is calculated using the per unit cost of Rs.11.25, which consists of Rs.1.40 per unit for direct materials, Rs.7.00 per unit for direct labor, and a manufacturing overhead rate of Rs.2.85. The overhead rate is calculated by multiplying the predetermined overhead rate of Rs.5.70 per direct labor hour times the direct labor hours per unit of one-half hour. Quantity Unit Cost Total Cost Direct Materials
Various
Rs. 1.40
Rs. 1.40
Direct Labor
.5 hour
14.00
7.00
Manufacturing Overhead .5 hour
5.70
2.85
Total Unit Cost Rs.11.25 Pickup Trucks Company Budgeted Income Statement For the Year 20X1
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Sales (100,000 × Rs.15)
Rs.1,500,000
Cost of Goods Sold (100,000 × Rs.11.25)
1,125,000
Gross Profit
375,000
Operating Expenses Selling Expenses
Rs.120,000
Administrative Expenses
81,000
Total Operating Expenses
201,000
Income from Operations
174,000
Interest Expense
2,880
Income before Income Taxes
171,120
Income Taxes (40%)
68,448
Net Income
Rs.102,672
CASH BUDGETING The cash budget indicates how much cash the company will have on hand at the end of each period, and also indicates when the company will need to borrow funds to cover temporary cash shortfalls, and when the company will have excess funds to invest in short-term financial instruments. The objective of the cash budget is to ensure that sufficient cash is available at all times to meet the level of operations that are outlined in the various budgets. Cash flow is so important that in some organizations, cash balances are projected for the end of each week, or even on a daily basis. Often, the cash budget is assembled from supporting schedules. These schedules show, for the period being budgeted, anticipated cash disbursements and cash receipts that arise from (1) operating activities, (2) additions and disposals of fixed assets, and (3) financing activities. The cash budget is one of the most important planning tools that an organization can use. It shows the cash effect of all plans made within the budgetary process and hence its preparation can lead to a modification of
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budgets if it shows that there are insufficient cash resources to finance the planned operations. It can also give management an indication of the potential problems that could arise and allows them the opportunity to take action to avoid such problems. A cash budget can show four positions. Management will need to take appropriate action depending on the financial position. Cash Position Short term surplus
Short term deficits
Long term surplus
Long term deficit
Appropriate management action Pay creditors early to obtain discount. Attempt to increase sales by increasing debtors and stocks. Make short term investments. Increase creditors. Reduce debtors. Arrange an overdraft. Make long term investments. Expand operations Diversify. Replace / update fixed assets Raise long term finance. i.e. issue shares Consider shut down or disinvestment opportunities.
ZERO-BASED BUDGETING In the normal budgeting process, the previous year's level of expenditure is often assumed to have been appropriate. The task of individuals preparing the budget is to decide what activities and funds should be added or subtracted. Such a process builds into an organization a bias towards continuing the same activities year after year. Zero-base budgeting, in contrast, enables the organization to look at its activities and priorities afresh. The previous year's resource allocation is not automatically considered as the basis of this year's allocation. Instead, each manager has to justify anew his/her entire budget request.
Uses of Zero-Based Budgeting 1. Efficient allocation of resources, as it is based on needs and benefits. 2. Drives managers to find cost effective ways to improve operations.
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3. Detects inflated budgets. 4. Useful for service departments where the output is difficult to identify. 5. Increases staff motivation by providing greater initiative and responsibility in decision-making. 6. Increases communication and coordination within the organization. 7. Identifies and eliminates wasteful and obsolete operations. 8. Forces cost centers to identify their mission and their relationship to overall goals.
Disadvantages of Zero-Based Budgeting 1. Difficult to define decision units and decision packages, as it is timeconsuming and exhaustive. 2. Forced to justify every detail related to expenditure. The R&D department is threatened whereas the production department benefits. 3. Necessary to train managers. Zero-based budgeting must be clearly understood by managers at various levels to be successfully implemented. Difficult to administer and communicate the budgeting because more managers are involved in the process. 4. Honesty of the managers must be reliable and uniform.
FLEXIBLE BUDGETING A flexible budget is a budget that is prepared for a range i.e. for more than one level of activity. The flexible budget is also known as a variable, dynamic, sliding scale, step budget. The underlying principle for a flexible budget is that every business is dynamic and ever changing. Thus, a flexible budget is developed for a range, say 8000-10000 units of production. Under this approach, if the actual production is 9000 units compared to the projected amount of 10000 units, the manager uses the flexible budget to project the costs for 9000 units of output in place of the budgeted 10000 units. The flexible budget covers a range of activity, is easy to change with a variation in production levels, and thus facilitates correct performance measurement and reporting.
Steps in flexible budgeting The following steps are involved in developing a flexible budget:
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1. Deciding the range of activity to which the budget is to be prepared 2. Determining the cost behavior patterns (fixed, flexible, semi-
variable) for each element of cost to be included in the budget 3. Selecting the activity levels in terms of production levels to prepare budgets at those levels 4. Preparing the budget at the pre-determined level of activity
Uses of flexible budgets The following are the main uses of a flexible budget: •
•
•
•
Accurate budgeting- Flexible budgets result in the preparation of more accurate budgets. Such budgets consider the output and accordingly estimate the costs to be incurred at that level of output Accurate performance measurement- Flexible budgeting incorporates changes in activity levels and compares actual performance with the budget in terms of output achieved. This facilities more meaningful comparison and evaluation of performance. Coordination- Flexible budgeting results in proper coordination between various departments of a company. For instance, if production is planned in relation to estimated sales, materials and labor are acquired to meet expected production needs Control tool- Such a budget acts as a control tool. Comparisons between the budgeted costs (at the actual production level) and actual costs form the basis for analyzing cost variances and fixing responsibility for the same.
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BUDGET: A budget is a plan for the future. Hence, budgets are planning tools, and they are usually prepared prior to the start of the period being budgeted. However, the comparison of the budget to actual results provides valuable information about performance. Therefore, budgets are both planning tools and performance evaluation tools. Budgets are part of a company's long-range planning system. While some portions of a long-range plan are concerned with the organization in five to ten years, the budget is the short-range portion of the plan. The following figure 1.1 shows that how the budgetary process fits into an overall general framework of planning, decision-making and control. 1. Establish objectives 2. Identify potential courses of action (i.e. strategies) Long-term planning process
3. Evaluate alternative strategic options 4. Select alternative courses of action 5. Implement long-term plan in the form of the annual budget
Annual budgeting process
6. Monitor actual results 7. Respond to divergencies from plan Figure 1.1 The role of long-term planning and budgeting within the planning, decision-making and control process
A budget is a quantitative plan for the future that assists the organization in coordinating activities. All large organizations prepare budgets. Many organizations prepare detailed budgets that look one year ahead, and budgets that look further into the future that contain relatively less detail and more general strategic direction.
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MULTIPLE FUNCTIONS/USES OF BUDGETS: Budgets serve a number of useful purposes. They include: 1. planning annual operations; 2. coordinating the activities of the various parts of the organization and ensuring that the parts are in harmony with each other; 3. communicating plans to the various responsibility centre managers; 4. motivating managers to strive to achieve the organizational goals; 5. controlling activities; 6. evaluating the performance of managers.
Planning The budgeting process ensures that managers do plan for future operations, and that they consider how conditions in the next year might change and what steps they should take now to respond to these changed conditions. This process encourages managers to anticipate problems before they arise, and hasty decisions that are made on the spur of the moment, based on expediency rather than reasoned judgment will be minimized.
Coordination The budget serves as a vehicle through which the actions of the different parts of an organization can be brought together and reconciled into a common plan. Without any guidance, managers may each make their own decisions, believing that they are working in the best interests of the organization.
Communication Through the budget, top management communicates its expectations to lower level management, so that all members of the organization may understand these expectations and can coordinate their activities to attain them.
Motivation
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The budget can be a useful device for influencing managerial behavior and motivating managers to perform in line with the organizational objectives. A budget provides a standard that under certain circumstances, a manager may be motivated to strive to achieve.
Control A budget assists managers in managing and controlling the activities for which they are responsible. By comparing the actual results with the budgeted amounts for different categories of expenses, managers can ascertain which costs do not conform to the original plan and thus require their attention.
STAGES IN BUDGETING PROCESS: The important stages are as follows: 1. communicating details of budget policy and guidelines to those people responsible for the preparation of budgets; 2. determining the factor that restricts output; 3. preparation of the sales budget; 4. initial preparation of various budgets; 5. negotiation of budgets with superiors; 6. coordination and review of budgets; 7. final acceptance of budgets; 8. ongoing review of budgets.
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USES OF VARIOUS BUDGETING TECHNIQUES MASTER BUDGETING The most common budgeting technique is to create a master budget which is the overall collection of budgets for the operation of the organization. It consists of the budgets for sales, manufacturing costs (materials, labor, and overhead) or merchandise purchases, selling expenses, and general and administrative expenses. These budgets are fixed, static or expected budgets.
Sales budget The sales budget is the starting point in putting together a comprehensive budget for a business. It includes the number of units to be sold and the selling price per unit. It is important to agree to the sales budget first because many other budgets are based on this data. Although its components are simple, getting a management team to agree on the number of units to be sold and the selling price per unit, the two items needed to prepare the budget, is often difficult and time- consuming. The Pickup Trucks Company, which makes trucks, has just completed its budgeting process for next year. Total expected sales are 100,000 trucks at a price of Rs.15.00 each. Its sales budget has been prepared on a quarterly basis as follows: The Pickup Trucks Company Sales Budget For the Year Ended December 31, 20X1 Quarter 1 Units
15,000
Selling Price Rs.15 Total Sales
Quarter 2
Quarter 3
Quarter 4
Total
17,000
28,000
40,000
100,000
Rs.15
Rs.15
Rs.15
Rs.15
Rs.225,000 Rs.255,000 Rs.420,000 Rs.600,000 Rs.1,500,000
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In addition to annual and quarterly sales budgets, monthly budgets are often prepared so sales can be tracked against expectations more frequently than once every three months.
Manufacturing costs Before preparing the direct materials, direct labor, and manufacturing overhead budgets, the production budget must be completed. Production budget. The production budget shows the number of units that must be produced. To budget for annual production, three things must be known: the number of units to be sold, the required level of inventory at the end of the year, and the number of units, if any, in the beginning inventory. If quarterly budgets are required, this same information is needed on a quarterly basis. Using the Pickup Trucks Company's quarterly sales budget and given that 15% of the next quarter's sales volume must be on hand before the quarter begins, the production budget by quarter can be prepared. Further assumptions are a 10% increase in sales in quarter one of next year compared to the current year's quarter-one sales and 2,250 units in inventory at the beginning of the year. Pickup Trucks Company Production Budget in Units for 20X1 Sales
15,000 17,000 28,000 40,000 100,000
Required Ending Inventory 2,550
4,200
6,000
2,475
2,475
Units Required
17,550 21,200 34,000 42,475 102,475
Beginning Inventory
(2,250) (2,550) (4,200) (6,000) (2,250)
Units to be Produced
15,300 18,650 29,800 36,475 100,225
Direct materials budget. The direct materials budget determines the number of units of raw materials to be purchased. It uses the number of units to be produced from the production budget, the required level of ending inventory for raw materials, and the number of units in beginning inventory. Once the number of units to be purchased is determined, it is multiplied by the cost per unit to determine the budgeted amount for raw materials purchases. The Pickup Trucks Company requires 10% of next quarter's production requirement for raw materials to be in its ending inventory. For example, because it takes five tires to make the special pickup truck (four Page 5 of 14
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plus the spare tire mounted on the side), at a cost of Rs.0.50 per tire, the raw materials purchases budget calculates 501,890 tires required at a cost of Rs.250,945. The units in the production budget are adjusted for units in ending and beginning inventories, multiplied by five (number of tires per pick up) to determine total tires to be purchased and then multiplied by Rs.0.50 to determine the cost of the tires needed. As a reminder, the production budget showed the following units for 20X1: Units Quarter 1
15,300
Quarter 2
18,650
Quarter 3
29,800
Quarter 4
36,475
Total
100,22 5 Pickup Trucks Company Raw Materials Budget For the Year 20X1 Quarter 1
Quarter 2 Quarter 3 Quarter 4
Total
Units to be produced
15,300
18,650
29,800
36,475
100,225
Number of tires per unit
×5
×5
×5
×5
×5
76,500
93,250
149,000
182,375
501,125
Required ending inventory
9,325
14,900
18,238
8,415
8,415
Total units required
85,825
108,150
167,238
190,790
509,540
Beginning inventory
(7,650)
(9,325)
(14,900)
(18,238)
(7,650)
Units to purchase
78,175
98,825
152,338
172,552
501,890
Cost per unit
× Rs.0.15
× Rs.0.15
× Rs.0.15
× Rs.0.15
× Rs.0.15
Cost of raw materials purchases
Rs.11,726
Rs. 14,824 Rs. 22,851 Rs. 25,883 Rs. 75,284
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This process is repeated for all the other raw material components used in producing a pickup truck. Direct labor budget. The direct labor budget shows the number of direct labor hours and the cost of the labor to determine the total cost of direct labor. Assume it takes one-half hour of labor to put together one pickup truck and each labor hour costs Rs.14.00. The total direct labor budget is for 50,113 (100,225 units × .5 hours per unit) hours at a cost of Rs.701,575 (Rs.14.00 per hour × 50,113 hours). The break out by quarter is shown in the following table. Pickup Trucks Company Direct Labor Budget For the Year 20X1 Quarter 1
Quarter 2
Quarter 3
Quarter 4
Total
15,300
18,650
29,800
36,475
100,225
Direct labor hours × .5 per unit
× .5
× .5
× .5
× .5
9,325
14,900
18,237.5
50,112.5
× Rs.14.00
× Rs.14.00
× Rs.14.00
× Rs.14.00
Rs.130,550
Rs.208,600
Rs.255,325
Rs.701,575
Units to be produced
Total direct labor hours
7,650
Cost per hour
× Rs.14.00
Cost of direct labor
Rs.107,100
Manufacturing overhead. The manufacturing overhead budget identifies the expected variable and fixed overhead costs for the year (or other period) being budgeted. The separation between fixed and variable costs is important because the Pickup Trucks Company uses a predetermined overhead rate for applying overhead to units produced. In preparing its budget, the Pickup Trucks Company has identified the following variable and fixed costs: indirect materials Rs.0.50 per unit, indirect labor Rs.1.00 per unit, maintenance Rs.0.75 per unit, annual depreciation Rs.12,000, supervisory salaries Rs.24,000, and property taxes and insurance Rs.21,000. The budget by quarter is: Pickup Trucks Company Manufacturing Overhead Budget For the Year 20X1
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Assignment No.2 Budgeting
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Quarter 1 Quarter 2 Quarter 3 Quarter 4
Total
Variable Costs Indirect Materials
Rs.7,650
Indirect Labor
15,300
18,650
29,800
36,475
100,225
Maintenance
11,475
13,988
22,350
27,356
75,169
34,425
41,963
67,050
82,069
225,507
3,000
3,000
3,000
5,700
14,700
6,000
6,000
6,000
6,000
24,000
5,250
5,250
5,250
5,250
21,000
14,250
14,250
14,250
16,950
59,700
Total Variable Costs
Rs.9,325
Rs14,900 Rs.18,238 Rs.50,113
Fixed Costs Supervisory Salaries Property Taxes and Insurance Depreciation Total Fixed Costs Total Manufacturing Overhead
Rs.48,675 Rs.56,213 Rs.81,300 Rs.99,019 Rs.285,207
Total Direct Labor Hours
7,650
9,325
Predetermined Overhead Rate
14,900
18,238
50,113 Rs.5.70
Selling expenses budget The budget for selling expenses includes the variable and fixed selling expenses. The variable expenses in the selling expenses budget are usually based on sales dollars. Assume the Pickup Trucks Company's variable expenses are sales commissions and delivery expense. Sales commissions are 4% of sales dollars, and delivery expense, also called freight out by some companies, is Rs.0.10 per unit sold. The company also has fixed sales salaries of Rs.50,000. The calculations for sales commissions and delivery expense, followed by the selling expenses budget, are shown in the following tables. Pickup Trucks Company Sales Commission and Delivery Expenses Budget Calculations For the Year 20X1
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Assignment No.2 Budgeting
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Sales Commission Expense Sales
Rs.225,000 Rs.255,000 Rs.420,000 Rs.600,000 Rs.1,500,000
Commission Rate
4%
Sales Commissions
Rs.9,000
4%
4%
4%
4%
Rs.10,200
Rs.16,800
Rs.24,000
Rs.60,000
Delivery Expense Units Sold
15,000
17,000
28,000
40,000
100,000
Cost per Unit
Rs.0.10
Rs.0.10
Rs.0.10
Rs.0.10
Rs.0.10
Delivery Expense Rs. 1,500 Rs. 1,700 Rs. 2,800 Rs. 4,000 Pickup Trucks Company Selling Expenses Budget For the Year 20X1
Rs.10,000
Variable Expenses Sales Commissions
Rs. 9,000 Rs.10,200 Rs.16,800 Rs.24,000 Rs. 60,000
Delivery Expense
1,500
Total Variable Expenses 10,500
1,700
2,800
4,000
10,000
11,900
19,600
28,000
70,000
12,500
12,500
12,500
50,000
Fixed Expenses Sales Salaries
12,500
Total Selling Expenses
Rs.23,000 Rs.24,400 Rs.32,100 Rs.40,500 Rs.120,000
General and administrative expenses budget The general and administrative expenses budget details the variable and fixed operating expenses for the general and administrative areas of the company. The Pickup Trucks Company has no variable administrative expenses. Its fixed expenses include salaries of Rs.60,000, rent expense of Rs.15,000, and office supplies of Rs.6,000. Pickup Trucks Company General and Administrative Expenses Budget For the Year 20X1
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Assignment No.2 Budgeting
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Variable Expenses None Fixed Expenses Salaries
Rs.15,000 Rs.15,000 Rs.15,000 Rs.15,000 Rs.60,000
Rent Expense
3,750
3,750
3,750
3,750
15,000
Office Supplies
1,500
1,500
1,500
1,500
6,000
Total General and Administrative Expenses
Rs.20,250 Rs.20,250 Rs.20,250 Rs.20,250 Rs.81,000
Budgeted Income Statement The budgeted or budgeted income statement is prepared after the operating budgets have been completed. The cost of goods sold on the income statement is calculated using the per unit cost of Rs.11.25, which consists of Rs.1.40 per unit for direct materials, Rs.7.00 per unit for direct labor, and a manufacturing overhead rate of Rs.2.85. The overhead rate is calculated by multiplying the predetermined overhead rate of Rs.5.70 per direct labor hour times the direct labor hours per unit of one-half hour. Quantity Unit Cost Total Cost Direct Materials
Various
Rs. 1.40
Rs. 1.40
Direct Labor
.5 hour
14.00
7.00
Manufacturing Overhead .5 hour
5.70
2.85
Total Unit Cost Rs.11.25 Pickup Trucks Company Budgeted Income Statement For the Year 20X1
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Assignment No.2 Budgeting
Use of Various Techniques of
Sales (100,000 × Rs.15)
Rs.1,500,000
Cost of Goods Sold (100,000 × Rs.11.25)
1,125,000
Gross Profit
375,000
Operating Expenses Selling Expenses
Rs.120,000
Administrative Expenses
81,000
Total Operating Expenses
201,000
Income from Operations
174,000
Interest Expense
2,880
Income before Income Taxes
171,120
Income Taxes (40%)
68,448
Net Income
Rs.102,672
CASH BUDGETING The cash budget indicates how much cash the company will have on hand at the end of each period, and also indicates when the company will need to borrow funds to cover temporary cash shortfalls, and when the company will have excess funds to invest in short-term financial instruments. The objective of the cash budget is to ensure that sufficient cash is available at all times to meet the level of operations that are outlined in the various budgets. Cash flow is so important that in some organizations, cash balances are projected for the end of each week, or even on a daily basis. Often, the cash budget is assembled from supporting schedules. These schedules show, for the period being budgeted, anticipated cash disbursements and cash receipts that arise from (1) operating activities, (2) additions and disposals of fixed assets, and (3) financing activities. The cash budget is one of the most important planning tools that an organization can use. It shows the cash effect of all plans made within the budgetary process and hence its preparation can lead to a modification of
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Assignment No.2 Budgeting
Use of Various Techniques of
budgets if it shows that there are insufficient cash resources to finance the planned operations. It can also give management an indication of the potential problems that could arise and allows them the opportunity to take action to avoid such problems. A cash budget can show four positions. Management will need to take appropriate action depending on the financial position. Cash Position Short term surplus
Short term deficits
Long term surplus
Long term deficit
Appropriate management action Pay creditors early to obtain discount. Attempt to increase sales by increasing debtors and stocks. Make short term investments. Increase creditors. Reduce debtors. Arrange an overdraft. Make long term investments. Expand operations Diversify. Replace / update fixed assets Raise long term finance. i.e. issue shares Consider shut down or disinvestment opportunities.
ZERO-BASED BUDGETING In the normal budgeting process, the previous year's level of expenditure is often assumed to have been appropriate. The task of individuals preparing the budget is to decide what activities and funds should be added or subtracted. Such a process builds into an organization a bias towards continuing the same activities year after year. Zero-base budgeting, in contrast, enables the organization to look at its activities and priorities afresh. The previous year's resource allocation is not automatically considered as the basis of this year's allocation. Instead, each manager has to justify anew his/her entire budget request.
Uses of Zero-Based Budgeting 1. Efficient allocation of resources, as it is based on needs and benefits. 2. Drives managers to find cost effective ways to improve operations.
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Assignment No.2 Budgeting
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3. Detects inflated budgets. 4. Useful for service departments where the output is difficult to identify. 5. Increases staff motivation by providing greater initiative and responsibility in decision-making. 6. Increases communication and coordination within the organization. 7. Identifies and eliminates wasteful and obsolete operations. 8. Forces cost centers to identify their mission and their relationship to overall goals.
Disadvantages of Zero-Based Budgeting 1. Difficult to define decision units and decision packages, as it is timeconsuming and exhaustive. 2. Forced to justify every detail related to expenditure. The R&D department is threatened whereas the production department benefits. 3. Necessary to train managers. Zero-based budgeting must be clearly understood by managers at various levels to be successfully implemented. Difficult to administer and communicate the budgeting because more managers are involved in the process. 4. Honesty of the managers must be reliable and uniform.
FLEXIBLE BUDGETING A flexible budget is a budget that is prepared for a range i.e. for more than one level of activity. The flexible budget is also known as a variable, dynamic, sliding scale, step budget. The underlying principle for a flexible budget is that every business is dynamic and ever changing. Thus, a flexible budget is developed for a range, say 8000-10000 units of production. Under this approach, if the actual production is 9000 units compared to the projected amount of 10000 units, the manager uses the flexible budget to project the costs for 9000 units of output in place of the budgeted 10000 units. The flexible budget covers a range of activity, is easy to change with a variation in production levels, and thus facilitates correct performance measurement and reporting.
Steps in flexible budgeting The following steps are involved in developing a flexible budget:
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Assignment No.2 Budgeting
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1. Deciding the range of activity to which the budget is to be prepared 2. Determining the cost behavior patterns (fixed, flexible, semi-
variable) for each element of cost to be included in the budget 3. Selecting the activity levels in terms of production levels to prepare budgets at those levels 4. Preparing the budget at the pre-determined level of activity
Uses of flexible budgets The following are the main uses of a flexible budget: •
•
•
•
Accurate budgeting- Flexible budgets result in the preparation of more accurate budgets. Such budgets consider the output and accordingly estimate the costs to be incurred at that level of output Accurate performance measurement- Flexible budgeting incorporates changes in activity levels and compares actual performance with the budget in terms of output achieved. This facilities more meaningful comparison and evaluation of performance. Coordination- Flexible budgeting results in proper coordination between various departments of a company. For instance, if production is planned in relation to estimated sales, materials and labor are acquired to meet expected production needs Control tool- Such a budget acts as a control tool. Comparisons between the budgeted costs (at the actual production level) and actual costs form the basis for analyzing cost variances and fixing responsibility for the same.
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