Budgeting & Profit Planning

8/9/2019 Budgeting & Profit Planning

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Tata McGraw Tata McGraw- -Hill Publishing Company Limited, Management AccountingHill Publishing Company Limited, Management Accounting 1717--11

Chapter 17Chapter 17

Budgeting and ProfitBudgeting and ProfitPlanningPlanning


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BUDGETING AND PROFITPLANNING

Planning Process

Preparation/Types of Budgets

Budget-Definition, Meaningand Purpose


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Planning ProcessPlanning ProcessBudgeting is a tool of planning. Planning involves specification of

the basic objectives that the organisation will pursue and thefundamental policies that will guide it. In operational terms,

it involves four steps:

(1) Objectives

Objectives are broad and long-range desired state or position in future.

(2) Goals

Goals are quantitative targets to be achieved in specified period.

(3) StrategiesStrategies represent specific course of action to achieve goals.

(4) Plans

The final step is the preparation of budgets/profit plans. It converts goalsand strategies into annual operating plans ..


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BudgetBudget

A budget is defined as a comprehensive and coordinated plan,expressed in financial terms, for the operations and resourcesof an enterprise for some specified period in the future.

The essential elements of a budget are:

(1) Plan(2) Financial terms(3) Operations and resources(4) Specific future period(5) Comprehensive coverage(6) Coordination


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The first ingredient of a budget is its plan. It includes two aspects whichhave a bearing on the operations of an enterprise. One set of factors, which

determine a firms future operations are wholly external and beyond itscontrol. The second set of factors affecting future activities are within thefirms control and discretion, that is, they are internal.

A budget is a mechanism to plan for the firms operations and resources.The operations are reflected in revenues and expenses.The plan also covers the resources of the firm. The planning of resourcesmeans the planning of the various assets and the sources of capital tofinance these assets. The assets could be fixed assets as well as currentassets.

Budgets are prepared in financial terms, that is, in terms of monetary valuesuch as the rupee, dollar, and so on. The reason is that the monetary unit isa common denominator.

1. Plan

2. Operations and Resources

3. Financial Terms


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A budget relates to a specified period of time, usually one year.

A budget is comprehensive in that all the activities and operations of an organisation are included in it. It covers the organisation as awhole and not only some segments. The modus operandi is thatbudgets are prepared for each segment/facet/activity/division of anorganisation.

Budgets are prepared for the different components/segments/divisions/ facets/activities of an organisation so as to takecare of the situations and problems of each component. Thebudgets for each of the components are prepared in harmony witheach another. This is called coordination.

4. Specified Future Period

5. Comprehensiveness

6. Coordination


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Budget PurposeBudget Purpose

The main objectives of budgeting are:

1. Explicit statement of expectations

2. Communication

3. Coordination,

4. Expectations as a framework for judging performance


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One purpose of budgeting is to state expectations in formal terms so that

most of the underlying assumptions may be identified. A firm has thebasic objective of optimising long-run profit. Its long-range goalsalso include survival, consumer satisfaction, employee

welfare, personal power and prestige, and so on.

Another purpose of budgeting is to communicate or inform others of thegoals and methods selected by top management. Since budgeting

deals with fundamental policies and objectives, it isprepared by top management.

However, a budget does not lay down a statement of expectations in rigidterms. A budget should be modified when necessary in the light of

the changes in the factors/assumptions on which theoriginal estimates were based.

1. Explicit Statement of Expectations

2. Communication


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Yet another purpose of budgeting is coordination. The term coordinationrefers to the operation of all departments of an organisation in

such a way that there is no bottleneck or imbalance.

Finally, a budget establishes expectations as a framework for judgingemployee performance.

In view of the above, coordination is a major function of budgeting.Budgets should be drafted in such a way that the operations

of the various departments are related to each other for the achievement of the overall goal.

3. Coordination

4. Expectations as a Framework for Judging Performance


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TYPES OF BUDGETSTYPES OF BUDGETSThe overall budget is known as the master budge. A

master budget normally consists of threetypes of budgets:

(i) Operating Budgets(i) Operating Budgets

(ii) Financial Budgets(ii) Financial Budgets

(iii) Special Decision Budgets(iii) Special Decision Budgets


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1. Operating Budget1. Operating Budget

1) Sales budget,2) Production budget,3) Purchase budget,4) Direct labour budget,5) Manufacturing expenses budget, and6) Administrative and selling expenses budget, and

so on.

Operating budgets relate to physical activities/operations such as sales, production,

and so on.

Operating budget has the following components


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2. Financial Budget2. Financial Budget

1) Budgeted income statement,

2) Budgeted statement of retained earnings,3) Cash budget, and4) Budgeted balance sheet.

Financial budgets are concerned with expectedcash flows, financial position and

result of operations.

Financial budget has the following components


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Cash BudgetCash BudgetCash budget is a device to help a firm to plan for and control the use of cash. It is a statement showing the estimated cash inflows and cashoutflows over the planning period. The principal aim of the cashbudget, as a tool to predict cash flows over a period of time,is to ascertain whether there is likely to be excess/shortage of cash at anytime.

The preparation of a cash budget involves several steps.

The first element of a cash budget is the selection of the period of the budget, that is, the planning horizon.

The second element of the cash budget is the selection/identification

of the factors that have a bearing on cash flows.The factors that generate cash are generally divided into two broadcategories:

(i) Operating (ii) Financial


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Operating Cash FlowOperating Cash Flow

The main operating factors/items which generate cashoutlfows and inflows over the time span of a

cash budget are tabulated in Exhibit 1.

Exhibit 1. Operating Cash Flow ItemsCash inflows/Receipts Cash outflows/Disbursements

1.Cash sales2.Collection of accounts

receivable3.Disposal of fixed assets

1. Accounts payable/Payable payments2. Purchase of raw materials

3. Wages and salary (pay roll)4. Factory expenses5. Administrative and selling expenses6. Maintenance expenses7. Purchase of fixed assets


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Financial Cash Flow ItemsFinancial Cash Flow Items

The major financial factors/items affecting generationof cash flows are depicted in Exhibit 2.

Exhibit 2. Financial Cash Flow ItemsCash inflows/Receipts Cash outflows/Payments

1. Loans/borrowings2. Sale of securities3. Interest received4. Dividend received5. Rent received6. Refund of tax7. Issues of new shares and securities

1. Income tax/tax payments2. Redemption of loan3. Re-purchase of shares4. Interest paid5. Dividends paid


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Example 1The following data relate to Hypothetical Limited:

Balance Sheet as at March 31, Current Year

Liabilities Amount Assets Amount

Accounts payable(all for March purchases)

Taxes payable(all for March income)

Share capitalRetained earnings

Rs 40,000

25,000

11,00,00010,26,800

_______21,91,800

CashAccounts receivable

(all from March sales)Inventories:

Raw materials (9,600 kgs Rs 3)Finished goods

(1,800 units Rs 35)Fixed assets:

Cost Rs 20,00,000Less: Accumulated

depreciation (4,50,000)

Rs 3,00,000

2,50,000

28,800

63,000

15,50,00021,91,800


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2. Sales forecasts: Assume the marketing department has developed thefollowing sales forecast for the first quarter of the next year and the sellingprice of Rs 50 per unit.

Month Units sales

AprilMayJune

9,00012,00016,000

3. The management desires closing inventory to equal 20 per cent of thefollowing months sales.

4. The manufacturing costs are as followsDirect materials: (5 kgs Rs 3) (per unit)Direct labour Variable overheadsTotal fixed overheads (per annum)

Rs 1559

7,20,0

005. Normal capacity is 1,20,000 units per annum. Assume absorption costing

basis.

6. Each unit of final product requires 5 kgs of raw materials. Assumemanagement desires closing raw material inventory to equal 20 per centof the following months requirements of production.


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7. Assume fixed selling and administrative expenses are Rs 20,000 per month and variable selling and administrative expenses are Rs 5 per unit sold.

8. All sales are on account. Payment received within 10 days from the date

of sale are subject to a 2 per cent cash discount. In the past, 60 per centof the sales were collected during the month of sale and 40 per cent arecollected during the following month. Of collections during the month of sale, 50 per cent are collected during the discount period. Accountsreceivable are recorded at the gross amount and cash discounts aretreated as a reduction in arriving at net sales during the month they aretaken.

9. Tax rate is 35 per cent.10. Additional information:

(a) All purchases are on account. Two-thirds are paid for in the monthof purchase and one-third, in the following month.

(b) Fixed manufacturing costs include depreciation of Rs 20,000 per month.

(c) Taxes are paid in the following month.(d) All other costs and/or expenses are paid during the month in which

incurred.From the foregoing information prepare a master budget for the month of April only.


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Solution

1.Production Budget

Particulars April May

Sales (units)Add: Desired closing inventory (0.20 next months sales)

Total finished goods requirementLess: Opening inventory

Required production (units)

9,0002,400

11,400(1,800)

9,600

12,0003,200

15,200(2,400)12,800

2.Manufacturing Cost BudgetParticulars April

Required production (units)Direct material cost (5 kgs Rs 3 per kg)Total direct material cost

Total direct labour cost (Rs 5 per unit)Total variable overhead cost (Rs 9 per unit)Total variable manufacturing costsAll fixed manufacturing overheads (Rs 7,20,000 12 months)Total manufacturing cost

9,600Rs 15

Rs 1,44,000

48,00086,400

2,78,40060,000

3,38,400


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3.Purchase Budget (Raw Materials)

Particulars April May

Production requirement (units)Raw material required for production @ 5 kgs per unit(kgs)

Add: Desired closing inventory (0.20 Mayrequirements)

Total requirements

Less: Opening inventoryPurchase requirementPurchase requirement (amount @ Rs 3 per kg)

9,600 ______48,000

12,80060,800

(9,600)51,200

Rs 1,53,600

12,800 _____64,000

4.Selling and Administrative Expenses Budget

Particulars April

Units salesVariable costs @ Rs 5 per unitFixed costsTotal selling and administrative expenses

9,000Rs 45,000

20,00065,000


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5. Cost of Goods Sold Budget

Particulars April

Units sold

Cost per unitVariableFixed (Rs 60,000 10,000 units)

Total cost

Rs 296

9,000

Rs 353,15,000

6. Budgeted Income Statement for the Month of April

Gross sales (9,000 Rs 50)Less: Cash discount (Rs 4,50,000 0.6 0.5 0.02)

Net salesLess: Cost of goods sold

Gross margin (unadjusted)Less: Capacity variance unfavourable (400 units Rs 6)

Gross margin (adjusted)Less: Selling and administrative expenses

Earnings before taxesLess: Taxes (0.35)

Earning after taxes

Rs 4,50,0002,700

4,47,3003,15,0001,32,300

2,4001,29,900

65,00064,90022,71542,185


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9. Proforma Balance Sheet as at March 31, Next Year

Liabilities Amount Assets Amount

Accounts payable(Rs 40,000 +

Rs 1,53,600 Rs 1,42,400)Taxes payable(Rs 25,000 + Rs 22,715

Rs 25,000)Share capitalRetained earnings

Rs 51,200

22,71511,00,00010,68,985

________22,42,900

CashAccounts receivable

(Rs 4,50,000 0.40)Inventories:

Raw material(12,800 Rs 3)

Finished goods(2,400 Rs 35)

Fixed assets:CostLess: Accumulated

depreciation

Rs 38,400

84,000

20,00,000

(4,70,000)

Rs 4,10,500

1,80,000

1,22,400

15,30,00022,42,900


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Special Decision BudgetsSpecial Decision BudgetsThe third category of budgets are special decision

budgets. They relate to inventory levels, break-evenanalysis, and so on.

Fixed Budgets

Budgets prepared at a single level of activity, with no prospect of modification in the light of changed circumstances, are referred toas fixed budgets.Flexible Budgets

The alternative to fixed budgets are flexible/variable/slidingbudgets

Fixed and Flexible BudgetsFixed and Flexible Budgets


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Flexible BudgetsFlexible BudgetsThe term flexible is an apt description of the essentialfeatures of these budgets. A flexible budget estimates costsat several levels of activity.

Its merit is that instead of one estimate, it contains severalestimates/plans in different assumed circumstances. Itis a useful tool in real world situations, that is, unpredictableenvironment.

A flexible budget, in a sense, is a series of fixed budgets andany increase/decrease in the level/volume of activity must bereflected in it.


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Each expense in each department/segment is to be

categorised into fixed, variable and mixed components.A budget may first be prepared at the expected level of activity, say, 100 per cent capacity. Additionalcolumns may then be added for costs below and above,90 per cent and 110 per cent capacity and so on.

The conceptual framework of flexible budgeting relates

to: (i) Measure of volume and (ii) Cost behaviour withchange in volume


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Table 1 Hypothetical LtdFlexible Budget (Maintenance Department)

Volume (labour-hours) 4,000 4,500 5,000 5,500 6,000

Variable costs:

Labour MaterialOthersMixed costs:Labour

MaintenanceOther suppliesDiscretionary fixed costs:TrainingExperimental methodsCommitted fixed costs:DepreciationRent, lease costTotal

Rs 6,0002,400

800

2,300

1,4002,500

1,5003,500

5,0003,500

28,900

Rs 6,7502,700

900

2,400

1,4502,750

2,0004,000

5,0003,500

31,450

Rs 7,5003,0001,000

2,500

1,5003,000

2,0004,000

5,0003,500

33,000

Rs 8,2503,3001,100

2,600

1,5503,250

2,0004,000

5,0003,500

34,550

Rs 9,0003,6001,200

2,700

1,6003,500

2,5004,500

5,0003,500

37,100


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Table 2: Hypothetical LtdFlexible Budget (Manufacturing Department)

Volume (machine-hours) 50 60 70 80 90

Variable costs:

Power

Helpers

Discretionary fixed costs:Training

Tools

Committed fixed costs:

Depreciation

Rent

Total

Rs 500

250

800

200

1,200

1,000

3,950

Rs 600

300

900

200

1,200

1,000

4,200

Rs 700

350

900

200

1,200

1,000

4,350

Rs 800

400

900

300

1,200

1,000

4,600

Rs 900

450

1,000

300

1,200

1,000

4,850


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Modified Flexible BudgetsModified Flexible BudgetsFlexible budgets, as a tool of planning and control, are superior to fixed budgets.

The major weaknesses of fixed budgets are their inability to:(i) Show the potential variability of various estimates used in the

preparation of the budget, and(ii) Indicate the range within which costs may be expected to vary. They

are, therefore, not useful in an uncertain and unpredictable environment.

Flexible budgets present estimates at different levels of activity, and aremore useful.

LimitationsFlexible budgets suffer from one limitation in that they do not explicitlyconsider the relative probability of a particular volume/cost beingachieved. This limitation can be overcome by using a modifiedflexible budget which will include columns for different levelsof estimates: most likely, optimistic and pessimistic.


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Table 3: Hypothetical LtdModified Flexible Budget (ManufacturingDepartment)

Pessimistic Most likely Optimistic

Volume (labour-hours) 4,250 5,000 5,850

Variable costs:Labour MaterialsOthers

Mixed costs:Labour MaintenanceOther supplies

Discretionary fixed costs:TrainingExperimental methods

Committed fixed costs:DepreciationRent, etc.

Total

Rs 6,3752,650

850

2,3501,4252,625

1,7503,750

5,0003,500

30,275

Rs 7,5003,0001,000

2,5001,5003,000

2,0004,000

5,0003,500

33,000

Rs 8,7753,5101,170

3,4251,5852,670

2,2504,250

5,0003,500

36,135

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