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PRBA007TOPIC THREE A

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The budgeting process: Planning business activities

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Define and describe budgets

ObjectivesObjectives

Once you have completed this part of the topic, you should be able to:

Define and describe budgets. Identify the steps in preparing a master budget.

Explain the difference between static and flexible budgets.


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11Objective

Define and 11 describe budgets.

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The following reading is in addition to the reading indicated in the Student Study Pack

Pages 569-573 of Juchau R

Additional ReadingAdditional Reading

Pages 569 573 of Juchau, R., Flanagan, J., Mitchell, G., Tibbits, G., Ingram, R.W., Albright, T.L., Baldwin, B.A., Hill, J., Accounting Information for Decisions, Revised 2nd Edition, 2009, Cengage Learning, Australia.

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THE COMPREHENSIVE PLANNING APPROACH INVOLVES

◦ THE DEFINITION AND THE DETAILED SPECIFICATION OF THE

ORGANISATION’S OBJECTIVES

◦ THE IDENTIFICATION OF THE COURSES OF ACTION AVAILABLE

PLANNINGPLANNING

◦ THE IDENTIFICATION OF THE COURSES OF ACTION AVAILABLE,

WITHIN THE LIMITS IMPOSED BY THE RESOURCES AT THE DISPOSAL

OF THE ORGANISATION

◦ THE SELECTION AND IMPLEMENTATION OF THE COURSE OF

ACTION WHICH MAXIMISES THE ACHIEVEMENT OF THE OBJECTIVES

OF THE ORGANISATION


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“Most people think the entire purpose of business is to make a profit.But profit is no more the purpose of business than eating is the purpose of living

Business Goals and ObjectivesBusiness Goals and Objectives

living.Both are essential, but neither is the point of the exercise. Business survives because it continually creates a better world for itself.”Petzinger, The Wall Street Journal (June 12 1998)

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The planning and the budgeting process must always address the business objectives of the organisation.

Business objectives refer to the desired

Business objectivesBusiness objectives

Business objectives refer to the desired ends of management

They should be:◦ the catalyst for all management decisions

◦ the basis for measuring actual accomplishments

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Although most organisations claim to have a singular objective – to make a profit, in reality all organisations have a number of


organisations have a number of objectives.


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Growth Objectives related to increased revenue, number of employees or range of products being produced.

Profitability Objectives concerned with actual profits to be earned or returns on investment.

Examples of business objectives

Market share Objectives expecting an increase in the market share.

Social responsibility Objectives recognising that as, a corporate citizen, an organisation should address general societal aims, for example, problems of pollution.

Employee welfare Objectives showing concern for employees in their working life and place of work, for example, providing a safe work environment.

Quality of product and service provision

Objectives requiring that only the best products and services be sold or improved over time.

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Objectives plus stakeholdersObjectives plus stakeholdersEach stakeholder, no matter what their key interest may happen to be, they will have a

good reason/s for promoting the ongoing prosperity of the business.

Examples of stakeholdersStakeholder Relation to the business organisation

Shareholders The owners, especially major investors, will want to contribute to the plans of the company.

Directors and management

People in senior positions, whether elected or employed, will want to ensure their positions and incomes are consideredmanagement ensure their positions and incomes are considered.

Employees Whether employers are employed in the short or long term, they will be concerned about security of tenure. As Maslow wrote, security of tenure is on the second rung of the hierarchy of needs.

Financial institutions Lenders or potential lenders will want to be aware of the intentions of their client.

Clients There is no point in producing or selling to clients who no longer need your product.

Suppliers It is always good to know that your suppliers can continue to provide your requirements as change takes place rather than always needing to ‘catching up’.

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Business Goals must be determinedbefore preparing a Budget

Business Goals are the desired outcomes of the business operations◦ E.g. to sell my business for $500,000 in 5 years time◦ E g to have a debt free business at the end of 3 years


◦ E.g. to have a debt free business at the end of 3 years◦ E.g. operate a franchise in every capital city within 5 years NOT “to maximise sales”, or NOT “to retire wealthy”

NOT “to be my own boss” or NOT “double size in two years” Business Goals must be

Measurable Clear and concise In writing Attainable


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Business Objectives are set to achieve business goals◦ E.g.

business goal– sell business for $500,000 in five yearsb i bj i


business objective– increase market share by 2% each year leading to $1,000,000 in sales in year five at 15% net profit per year◦ Usually several objectives (outcomes of strategy)

to achieve business goal

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GOALSGOALSThe Main AIM(s)The main thing(s)we want to get to

The terms “Goals” and “Objectives” are often interchanged.It doesn’t really matter so long as you have a good view and understanding of what the context is, in which the terms are used

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STRATGEYSTRATGEYis HOW we get to our aim(s)


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OBJECTIVES th t are the steps

along the way

Linked to strategyoften called:- Critical success factors- Key performance indicators etc

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CHECKING RESULTSMonitoring or checkingMonitoring or checkingon how we are goingalong the way.So we can assured that weare on target or so we can do better

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Objectives generally relate to various operational functions that fall into the following broad categories


categoriesMarketingMarketing

ProductionProduction PurchasingPurchasing

PersonnelPersonnel FinancialFinancialAdministration and CapacityAdministration and Capacity


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Business performance is a function of ALL the activities of the TOTAL operation.

Business Plan must also consider ll h i i i f h TOTAL

Managing Operational FunctionsManaging Operational Functions

all the activities of the TOTALoperation

Effective management of the TOTAL operation requires planning as well as control of EACH operating function.

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For larger organisations, planning:

i di ti

Business planningBusiness planning

gives direction reduces the impact of changeminimises waste and redundancy sets a basis for control within the organisation.

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Levels of planningLevels of planning

• usually cover a period in excess of five years.

Long-term plans

• cover between two and five years.

Intermediate plans

• usually covers one year.

A short-term plan


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A common understanding of ‘budgetbudget’ is that it represents a spending allowance.

DEFINITIONS DEFINITIONS

This definition applies in accounting only when the resources are of a special kind.

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"In a business enterprise a budget a budget is the formal statement of a management's goals and objectives expressed in financial terms for a specific future period of time..."

DEFINITIONS DEFINITIONS

p pDeCoster & Schafer

"A Budget A Budget is a quantitative expression of a plan of action and an aid to coordination and implementation..." Horngren

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"BudgetsBudgets state formally - in terms of expected transactions - the decisions of all levels of management ◦ about the resources to be acquired,

how they are to be used

DEFINITIONSDEFINITIONS

◦ how they are to be used, ◦ and what ought to result.

BudgetsBudgets put the details of management plans for operations in money units, so that the results may be projected into expected financial statements."W.J. Vatter


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Budgeting deals with the future

It is the process aimed at predicting the level at which any activity of a business organisation will operate in a future time period.

BudgetingBudgeting

Based upon those principles, estimates are made of all the operational items leading to a budgeted statement of financial performance.

The master budget concludes with the budgeted statement of financial position at the end of the budget period.

Bear

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PLANNING & FORECASTING◦ Formulation of Policies◦ Detailed Planning of Future Action◦ Preparation of EstimatesCO ORDINATION & COMMUNICATION

Reasons for Business PlanningReasons for Business Planning

CO-ORDINATION & COMMUNICATION◦ Motivation & Goal Congruence

CONTROL◦ Assignment of Responsibility◦ Measurement of Actual Results◦ Comparison of Actual to Expected Diagnosis and Correction

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The annual budget (or master budget) is a comprehensive set of budgets that covers all aspects of a firm’s activities◦ Consists of several interdependent budget

schedules

The annual budget: a planning toolThe annual budget: a planning tool

schedules◦ Financial budgets◦ Operating budgets◦ In large organisations: a comprehensive

process, formal budgeting procedures taking several months◦ In smaller organisations: less formal

process(cont.)


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Budgets are developed for specific time periods

Rolling budgets (or continuous budgets) are continually updated by

The annual budget: a planning tool The annual budget: a planning tool (cont.)(cont.)

g y p yperiodically adding a new time period, such as a quarter, and dropping the period just completed

Budgets will vary in their level of detail, often dependent on the size and complexity of the organisation

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Budgets commence with an understanding of the strategy of the organisation

The budget should support the

Strategic plans and budget Strategic plans and budget assumptionsassumptions

The budget should support the strategic plans

The budget is based on various assumptions about the competitive environment and the economic environment for the coming year

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STANDARDSTANDARD◦ a level of quality which is regarded as normal, adequate, or acceptable◦ serving as a basis of weight, measure, value, comparison, or judgement

STANDARDS STANDARDS —— PERFORMANCE PERFORMANCE BENCHMARKSBENCHMARKS

value, comparison, or judgement◦ normal, adequate, acceptable, or averageMacquarie Concise Dictionary

A STANDARD COSTA STANDARD COST◦ is a pre-determined cost based on normal/expected levels of usage


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A variety of methods may be used to set cost standards

Analysis of historical data◦ Can provide a good basis for predicting future costs

Setting standardsSetting standards

future costs◦May need to be adjusted to reflect expected movements in price levels or technological changes in the product process◦Must be used with care as changes can make those costs irrelevant and can include inefficiencies of the past (cont.)

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Engineering methods◦ The focus is on what the product should cost in the

future◦ There is a need to determine how much material

should be required and how much direct labour should be used in the production processTime and motion studies may be conducted to

Setting standards (cont.)Setting standards (cont.)

◦ Time and motion studies may be conducted to determine how long it should take for workers to perform each step in a production process

◦ In practice, both historical cost analysis and engineering methods may be used together

Participation in standard setting may lead to greater commitment to meeting those standards

(cont.)

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Practical standards are the minimum attainable costs under normal operating conditions, with allowances made for downtime and wastage◦ May encourage more positive and

Setting standards (cont.)Setting standards (cont.)

y g pproductive attitudes among employees compared to perfection standards◦ Including allowances for idle time, material

wastage or normal spoilage, may encourage inefficiency and waste◦ Some companies build continuous

improvements into standards to make them more demanding (cont.)


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INDICATE WHAT IT SHOULD COST TO PRODUCE ONE BATCH OR UNIT OF PRODUCT UNDER EFFICIENT OPERATING CONDITIONS

ARE SET USING ENGINEERING COST

STANDARD COSTSSTANDARD COSTS

ARE SET USING ENGINEERING COST DATA, HISTORICAL COST DATA, TARGET COSTING, AND/OR CONTINUOUS IMPROVEMENT COSTING

FLEXIBLE BUDGETS ARE BASED ON STANDARD COSTS

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Price standardsPrice standards specify how much should be paid for the quantity of the input to be used.

Quantity standardsQuantity standards specify how much

STANDARD COSTSSTANDARD COSTS

yy p yof the input should be used per unit of output.

Unit standard costUnit standard cost is the product of these two standards:Standard price Standard price Standard Quantity Standard Quantity (SP (SP SQ)SQ)

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COMPARISON OFCOMPARISON OFACTUAL, NORMAL AND STANDARD ACTUAL, NORMAL AND STANDARD COSTSCOSTS

DIRECT COSTS

ACTUAL COSTING

NORMAL COSTING

STANDARD COSTING

Actual Inputstimes

Actual Prices

Actual Inputstimes

Actual Prices

Standard Inputs allowed for actual output

achievedtimes

Standard Prices

VARIABLE FACTORY OVERHEAD

FIXED FACTORY OVERHEAD

Actual Inputstimes

Actual Overhead

Rates

Actual Inputstimes

Budgeted Overhead

Rates


achievedtimes

Budgeted Overhead Rates

Actual Inputstimes

Actual Overhead

Rates

Actual Inputstimes

Budgeted Overhead

Rates


achievedtimes

Budgeted Overhead Rates


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Cost Management

Planning and Control

Usage of Standard Costing Usage of Standard Costing SystemsSystems

Decision Making and Product Costing

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A budgetbudget is a detailed plan describing the use of financial and operating resources over a specific period.

Overview of the master budgetOverview of the master budget

A master budget is a collection of related budgets covering sales, production, purchasing, labour, manufacturing overhead, administrative expenses, and financing activities.

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Components of a master Components of a master budgetbudget

Sales budget

Production budget

Exhibit 1Exhibit 1

Pro forma income statement

Direct materials budget

Direct labourbudget

Mfg. overhead budget

Admin. expense budget


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Direct labourbudget

Mfg. overhead budget

Admin. expense budget

Pro forma

Exhibit 1Exhibit 1 Components of a master budget

Pro forma income

statement

Pro forma balance sheet

Capital budget

Cash budget

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22Objective

Identify the steps 22 in preparing a master budget.

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The sales budget projects revenues from sales of a company’s products or services.

Sales budget


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Sales budgetExhibit 2Exhibit 2

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Sales budgetschedule of cash receipts

Exhibit 2Exhibit 2

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The production budget identifies the amount of a product that must be produced to meet a company’s needs for sales and

Production budget

company’s needs for sales and inventory.


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Production budget=

Production budget

Expected sales (in units)

+Desired ending inventory (in units)

–Beginning inventory (in units)

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Production budgetExhibit 3Exhibit 3

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The direct materials budgetidentifies the amount of materials that will be required to support a company’s total production


company’s total production needs.


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Units to be produced x raw materials per unit

+ Desired ending raw

Direct materials budgetFrom the

production budget

Direct materials

budget

materials inventory–

Beginning raw materials inventory

=Raw materials to be

purchased

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Production units 1 400Raw materials per unit (kg) x 5Production requirements (kg) 7 000

Q1 Q23 200x 5

16 000

Direct materials budgetFrom the

production budget

Production requirements (kg) 7 000Add desired ending inventory 1 600Total needs (kg) 8 600Less: Beginning inventory (kg) 700Total materials to be purchased 7 900

16 0001 800

17 800

Materials to purchase ($0,60/kg) $4 740 $9 720

16 2001 600

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Direct materials budgetExhibit 4Exhibit 4


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Direct materials budget schedule of cash disbursements

Exhibit 4Exhibit 4

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The direct labour budget identifies the labour resources required to meet production needs.

Direct labour budget

• Each unit requires 48 minutes of labour to produce (0.8 hours), and costs $7.50 per hour.

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Q1Total units to produce 1 400Hours per unit x 0.80T t l h i d 1 120

Direct labour budget

From the production budget

Total hours required 1 120Labour rate per hour x $7.50Total labour cost $8 400


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Direct labour budgetExhibit 5Exhibit 5

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The manufacturing overhead budget provides a schedule of all costs of production other than direct materials and direct labour.

Manufacturing overhead budget

• Kirkland applies manufacturing overhead using a rate of $2 per direct labour hour.

• Fixed overhead per quarter is $6060.

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Q1Total production (units) 1 400Hours per unit x 0.80Total hours required 1 120


Total hours required 1 120Overhead cost per hour x $2Budgeted variable overhead $2 240Budgeted fixed overhead 6 060Total budgeted manufact. overhead $8 300


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Exhibit 6Exhibit 6

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The selling and administrative expense budget contains a list of anticipated expenses for the period for activities other than

Selling and administrative Selling and administrative expense budgetexpense budget

period for activities other than manufacturing.

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Selling and administrative expense budget

Exhibit 7Exhibit 7


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The pro forma income statement is a key schedule in the master budget, providing a forecast of profitability for the planning

Pro forma budgeted Pro forma budgeted income statementincome statement

profitability for the planning period.

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Pro forma budgeted Pro forma budgeted income statementincome statement

Exhibit 8Exhibit 8

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33Objective

Explain the difference between 33 difference between static and flexible budgets.


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A pro forma income statement based on a single level of activity is called a static budget

Pro forma flexible budget income statement

called a static budget.

When activity levels can vary, a flexible budget allows the calculation of profit for a range of possible sales activity levels.

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Central concept◦ If you can tell me what your actual activity was for the period, I will tell you what your costs and revenue

Flexible budgetingFlexible budgeting

you what your costs and revenue should have beenshould have been.◦ As distinct from what was originally budgeted for using a different level of anticipated activity

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Show what costs would havebeen budgeted at the actual level ofactivity.

Flexible budgetingFlexible budgeting

activity. May be prepared for any activity level in the relevant range.

Reveal variances due to good cost control or lack of cost control.

Improves performance evaluation.


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To flex a budget for different activity levels, we must know how costs behave with changes in activity levels

Flexible budgeting

activity levels.◦ Total variable costs change in direct proportion to changes in activity.◦ Total fixed costs remain unchanged within the relevant range.

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Pro forma flexible budget Pro forma flexible budget income statementincome statement

Exhibit 9Exhibit 9

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The cash budget has four major sections:

Cash budgetCash budget

• Cash receiptsC h d b• Cash disbursements

• Cash excess/deficiency• Financing requirements


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Q1Receipts:Collections on account (Exhibit 2) 23 000Less: Disbursements:Direct materials (Exhibit 4) 4 950Direct labour (Exhibit 5) 8 400Manufacturing overhead (Exhibit 6) 6 800S lli d d i i i (E hibi 7) 8 300

Cash budgetExhibit 10Exhibit 10

Selling and administrative (Exhibit 7) 8 300Income taxes (Exhibit 8)($7200/4) 1 800Equipment purchases 3 000Dividends 1 000Total disbursements 35 250Change in cash (12 250)Cash balance beginning 4 250Excess (deficiency) of cash (8 000)

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Cash budgetExhibit 10Exhibit 10

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The pro forma budgeted balance sheet identifies expected amounts of assets, liabilities and owner’s equity at the end of the budget

Pro forma budgeted balance sheetPro forma budgeted balance sheet

equity at the end of the budget period.


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Pro forma budgeted balance sheet

Exhibit 11Exhibit 11

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Because assumptions can be wrong, it is often desirable to determine how sensitive budget outcomes are to the assumptions used in developing the budget. Scenarios investigated include:

Sensitivity analysis in budgeting

• Most likely case• Worst case• Best case

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Sensitivity analysis in budgeting

Exhibit 12Exhibit 12

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