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BUDGETING WHA WHAT T IS A BU BUDGET? DGET? A budget could be defined as ‘a quantified plan of action relating to a given period of time’. For a budget to be useful it must be quantified. For example, it would not be particularly useful for the purposes of planning and control if a budget was set as follows: ‘We plan to spend as little as possible in running the printing department this year’; or ‘We plan to produce as many units as we can possibly sell this quarter’. These are merely vague indicators of intended direction; they are not quantified plans. They will not provide much assistance in management’s task of planning and controlling the organization. These ‘budgets’ could perhaps be modified as follows: ‘Budgeted revenue expenditure for the printing department this year is GH ¢60,000’; and ‘Budgeted production for the quarter is 4,700 units’. The quantification of the budgets has provided: (a) a definite target for planning purposes; and (b) a yardstick for control purposes. THE B BUDGET UDGET PERIOD You may have noticed that in each of these ‘budgets’ the time period was different. The first budget was prepared for a year and the second budget was for a quarter. The time period for which a budget is prepared and used is called the budget period. It can be any length to suit management purposes but it is usually one year.

1

THE PURPOSES OF B BUDGETING UDGETING Budgets have two main roles: (1) They act as authorities to spend, that is, they give authority to budget managers to incur expenditure in their part of the organization; (2)

They act as comparators for current performance, by providing a

yardstick against which current activities can be monitored. These two roles are combined in a system of budgetary planning and control .

BUDGET UDGETAR AR ARY Y PLANNING AND CONTR CONTROL OL Planning the activities of an organization ensures that the organization sets out in the right direction. Individuals within the organization will have definite targets which they will aim to achieve. Without a formalized plan the organization will lack direction and managers will not be aware of their own targets and responsibilities. Consider two companies, A and B. You are told that both achieve profits of GH¢1,000 during the year. If you are now told that company A had a budgeted profit of GH¢2,000 and company B had budgeted for a profit of GH¢500 you now have much more information about the two companies and their performances. A formalized plan will help to ensure a coordinated approach, and the planning process itself will force managers to continually think ahead, planning

and

reviewing

their

activities

in

advance.

Budgeting

forces

managers to appreciate how their activities relate to those of other managers within the organization. However, the budgetary process should not stop with the plan. The organization has started out in the right direction but to ensure that it continues on course it is the management’s responsibility to exercise control. Control is best achieved by comparing the actual results with the original plan. Appropriate action can then be taken to correct any deviations from the plan.

2

The comparison of actual results with a budgetary plan, and the taking of action to correct deviations, is known as feedback control. The two activities of planning and control must go hand in hand. Carrying out the budgetary planning exercise without using the plan for control purposes is performing only part of the task. LEVELS OF B BUDGETING UDGETING Strategi Strategic c planning, budgetar budgetary y planning and operationa operationall planning It will be useful at this stage to distinguish in broad terms between three different types of planning: (1)

Strategic planning;

(2)

Budgetary planning;

(3)

Operational planning.

These three forms of planning are interrelated. The main distinction between them relates to their time span which may be short term, medium term or long term. The short term for one organization may be the medium or long term for another, depending on the type of activity in which it is involved. STRA STRATEGIC TEGIC PLANNING Strategic planning is concerned with preparing long-term action plans to attain the organization’s objectives. Strategic planning is also known as corporate planning or long-range planning.

BUDGET UDGETAR AR ARY Y PLANNING Budgetary planning is concerned with preparing the short-to medium-term plans of the organization. It will be carried out within the framework of the strategic plan. An organization’s annual budget could be seen as an interim step towards achieving the long-term or strategic plan. OPERA OPERATIONAL TIONAL PLANNING

3

Operational planning refers to the short-term or day-to-day planning process. It is concerned with planning the utilization of resources and will be carried out within the framework set by the budgetary plan. THE B BUDGET UDGET PR PROCESS OCESS The process of preparing and using budgets will differ from organization to organization. However there are a number of key requirements in the design of a budgetary planning and control process. COORDINA COORDINATION: TION: THE B BUDGET UDGET COMMITTEE The need for coordination in the planning process is paramount. For example, the purchasing budget cannot be

prepared without reference to the

production budget, and it may be necessary to prepare the sales budget before the production budget can be prepared. The best way to achieve this coordination is to set up a budget committee. The budget committee should comprise representatives from all functions in the organization. There should be

a

representative

from

sales,

a

representative

from

marketing,

a

representative from human resources and so on. The budget committee should meet regularly to review the progress of the budgetary planning process and to resolve problems that have arisen. These meeting will effectively bring together the whole organization in one room, to ensure a coordinated approach to budget preparation. THE B BUDGET UDGET MANU MANUAL AL Effective budgetary planning relies on the provision of adequate information to the individuals involved in the planning process. Many of these information needs are contained in the budget manual. A

budget

manual

is a

collection of

documents which contains

information for those involved in the planning process.

4

key

THE PRINCIP PRINCIPA AL BU BUD DGET F FACT ACT ACTOR OR The principal budget factor (key factor) is the factor which limits the activities of the organization. The early identification of this factor is important in the budgetary planning process because it indicates which budget should be prepared first. The principal budget factor is also known as the limiting factor. For example, if sales volume is the principal budget factor, then the sales budget must be prepared first, based on the available sales forecasts. All other budgets should then be linked to this. Alternatively machine capacity may be limited for the forthcoming period and therefore machine capacity is the principal budget factor. In this case, the production budget must be prepared first and all other budgets must be linked to this. Failure to identify the principal budget factor at an early stage could lead to delays at a later stage when managers realize that the targets they have been working with are not feasible. Supplementar Supplementary y rreading eading – T The he inter interrr ela elationship tionship of budgets The critical importance of the principal budget factor stems from the fact that all budgets are interrelated. For example, if sales is the principal budget factor this is the first budget to be prepared. This will then provide the basis for the preparation of several other budgets including the production budget. However, the production budget cannot be prepared directly from the sales budget

without

a

consideration

of

inventory

policy.

For

example,

management may plan to increase finished goods inventory. Production quantities would then have to be higher than the budgeted sales level.

5

FUNCTIONAL B BUDGETS UDGETS AND THE MASTER B BUDGET UDGET A master budget for the entire organization brings together the departmental or activity budgets for all the departments or responsibility centres within the organization. The master budget is a summary of all the functional budgets. It usually comprises the budgeted income statement, budgeted statement of financial position and budgeted cash flow statement. It is this master budget which is submitted to senior managers for approval because they should not be burdened with an excessive amount of detail. The master budget is designed to give the summarized information that they need to determine whether the budget is an acceptable plan for the forthcoming period. The structure of a budget depends on the nature of the organization and its operations. In a manufacturing organization, the budgeting process will probably consist of preparing several functional budgets, beginning with a sales budget. 

Sales budget budget. Budget for future sales, expressed in revenue terms and possibly also in units of sale.



Production budget budget. A production budget follows on from the sales budget, since production quantities are determined by sales volume. The production volume will differ from sales volume by the amount of any planned increase or decrease in inventories of finished goods (and work in progress).

Subsidiary budgets must be prepared for materials, labour and production overheads.

6



Direct materials usage budget budget. This is a budget for the quantities and cost of the materials required for the planned production quantities.



Mate Materials rials purc purchasing hasing bud budget get get. This is a budget for the cost of the materials to be purchased in the period. The purchase cost of direct materials will differ from the material usage budget if there is a planned increase or decrease in direct materials inventory. The purchases budget should also include the purchase costs of indirect materials.



Direct labour budget budget. This is a budget of the direct labour costs of production. If direct labour is a variable cost, it is calculated by multiplying the production quantities (in units) by the budgeted direct labour cost per unit produced. If direct labour is a fixed cost, it can be calculated by estimating the payroll cost.



Production overheads verheads. Budgets can be produced from production overhead costs. Where a system of absorption costing is used, overheads are allocated and apportioned, and budgeted absorption rates are determined.



Administration and sales and distribu overheads distribution tion overheads erheads. Other overhead costs should be budgeted.



Budgeted income state statement, ment, cash budget and statement of fi financial nancial position position. Having prepared budgets for sales and costs, the master budget can be summarized as an income statement for the period, a cash budget (or cash flow forecast) and a statement of financial position as at the end of the budget period.

7

BUDGET PREP PREPARA ARA ARATION TION These stages in budget preparation are illustrated in the following diagram.

SALES BUDGET

Step 1

PRODUCTION BUDGET

Step 2

RAW MATERIALS

FACTORY OVERHEADS

LABOUR

Step 3

COST OF GOODS SOLD BUDGET SELLING AND DISTRIBUTION EXPENSES BUDGET

GENERAL AND ADMINISTRATION EXPENSES BUDGET

Step 4

MASTER

BUDGET

Step 5

BUDGETED INCOME STATEMENT

Step 6

CASH BUDGET

CAPITAL EXPENDITURRE BUDGET

STATEMENT OF FINANCIAL POSITION

8

Step 7

Material losses in production and idle time must be taken account of in the material and labour budgets.

The best way to see how budgets are prepared is to work through an example. Illustration 1 A company manufactures two products, Milo and ‘This way chocolate drink’ (DWCD). Standard cost data for the products for next year are as follows:

Product Milo

Product DWCD

per unit

per unit

Direct material: X at GH¢2 per kg

24 kg

30 kg

Y at GH¢5 per kg

10 kg

8 kg

Z at GH¢6 per kg

5 kg

10 kg

Direct wages: Unskilled at GH¢6 per hour

10 hours

5 hours

6 hours

5 hours

Skilled at GH¢10 per hour

Budgeted inventories for next year are as follows:

Product Milo

Product DWCD

units

units

1 January

400

800

31 December

500

1,100

Material X Kg

Material Y kg

9

Material Z kg

1 January

30,000

25,000

12,000

31 December

35,000

27,000

12,500

Budgeted sales for next year: product Milo 2,400 units; product DWCD 3,200 units. You are required to prepare the following budgets for next year:

(a) Production budget, in units; (b) Material usage budget, in kilos; (c) Material purchases budget, in kilos and GH¢; (d) Direct labour budget, in hours and GH¢.

SOL SOLUTION UTION (a) PRODUCTION B BUDGET UDGET FOR NEXT YEAR

Product Milo Sales units required

units

units

2,400

3,200

500

1,100

2,900

4,300

400

800

2,500

3,500

Add Closing inventory at end of year Less opening inventory Production units required

Product DWCD

(b) MA MATERIAL TERIAL USAGE B BUDGET UDGET FOR NEXT YEAR

Material X Kg

Material Y kg

Material Z kg

Requirements for production: Product Aye Product Bee

1

60,000

25,000

12,500

105,000

28,000

35,000

10

Total material usage

165,000

53,000

47,500

Note 1: Material X for product Aye: 2,500 units produced x 24 kg = 60,000 kg The other material requirements are calculated in the same way. (c) MA MATERIAL TERIAL PURCHASES B BUDGET UDGET FOR NEXT YEAR

Material X

Material Y Material Z

Kg Material required for production Closing inventory at end of year

Less opening inventory Material purchases required Standard price per kg Material purchases value

kg

165,000 35,000

kg

53,000

47,500

27,000

12,500

200,000

80,000

60,000

30,000

25,000

12,000

170,000

55,000

48,000

GH¢5

GH¢6

GH¢2 GH¢340,000

GH¢275,000 GH¢288,000

TOTAL (340,000 + 275,000 +288,000) =GH¢903,000

(d) DIRECT LABOUR B BUDGET UDGET FOR NEXT YEAR

Unskilled labour hours

Skilled labour

Total

hours

Requirements for production: Product Aye

1

25,000

15,000

Product Bee

17,500

17,000

Total hours required

42,500

Standard rate per hour Direct labour cost

32,500

GH¢ GH¢255,000

11

GH¢325,000 GH¢580,000

Note 1: Unskilled labour for product Aye: 2,500 units produced x 10 hours = 25,000 hours The other labour requirements are calculated in the same way.

WAC manufactures two products, X and Y, and is preparing its budget for 2014. Both products are made by the same grade of labour T. The company currently holds 800 units of X and 1,200 units of Y in inventory, but 250 of these units of Y have just been discovered to have deteriorated in quality, and must therefore be scrapped. Budgeted sales of X are 3,000 units and of Y 4,000 units, provided that the company maintains finished goods inventories at a level equal to three months sales. Grade T labour was originally expected to produce 1(one) unit of X in 2 (two) hours and 1 (one) unit of Y in 3 (three hours), at an hourly rate of GH¢2.50 per hour. In discussions with trade union negotiators, however, it has been agreed that the hourly wage rate should be raised by GH¢0.50 per hour, provided that the times to produce X and Y are reduced by 20%. Required: prepare the production budget and direct labour budget for 2014.

SOLUTION

SALES ADD CLOSING STOCK LESS OPENING STOCK LESS SCRAP PRODUCTION UNITS

PRODUCTION BUDGET X 3,000 750 3750 800 800 2,950

Y 4,000 1,000 5,000 1200 -250

-950 4,050

LABOUR B BUDGET UDGET X GRADE T

(1.6HRS × 2,950×GH¢3)

14,160 12

Y (2.4HRS × 4050 × GH¢3)

29,160

LABOUR NEGOTIATION CURRENT RATE PER HOUR ¢2.50 NEGOTIATED RATE = 0.50 + 2.50 =GH ¢3 CURRENT HOUR PER UNIT OF PRODUCT X = 2HOURS NEGOTIATED HOUR PER UNIT OF PRODUCT X = (2HOURS × 0.80) = 1.6HOURS PER UNIT

CURRENT HOUR PER UNIT OF PRODUCT

Y = 3HOURS

NEGOTIATED HOUR PER UNIT OF PRODUCT X = (3HOURS × 0.80) = 2.4HOURS PER UNIT

13

THE CASH B BUDGET UDGET The cash budget is one of the most vital planning documents in an organization. It will show the cash effect of all of the decisions taken in the planning process. Management decisions will have been taken concerning such factors as inventory policy, credit policy, selling price policy and son on. All of these plans will be designed to meet the objectives of the organization. However, if there are insufficient cash resources to finance the plans they may need to be modified or perhaps action might be taken to alleviate the cash restraint. A cash budget can give forewarning of potential problems that could arise so that managers can be prepared for the situation or take action to avoid it.

The use of forecasts to modify actions so that potential threats are avoided or opportunities exploited is known as feed-forward control. There are four possible cash positions that could arise:

Cash position 





Possible management action

Short-term

Arrange a bank overdraft, reduce receivables and inventories,

deficit

increase payables

Long-term

Raise long-term finance, such as long-term loan capital or share

deficit

capital

Short-term

Expand or diversify operations, replace or update non-current

surplus 

assets

Long-term

Expand or diversify operations, replace or update non-current

surplus

assets<...