Profit Planning, Activity-Based Budgeting, and e-Budgeting

1

Budgeting

Dr. Varadraj Bapat

Module 14.

Management Accounting Dr. Varadraj Bapat, IIT Mumbai 2

Index

Introduction

Objectives

Advantages

Components of Budgetary Control System

Types of Budget

Zero Base Budgeting

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Budget

Budget refers to an estimated statement. It is prepared by companies as well as government. It is for the purpose of attaining some goal.

Management Accounting Dr. Varadraj Bapat, IIT Mumbai

Dr. Varadraj Bapat 4

Budget

Budget can be defined as a financial and / or quantitative statement prepared and approved prior to a defined period of time of the policy to be pursued during that period for the purpose of attaining a given objective.


Budget

It may include income, expenditure and employment of capital. It is often used for control purpose.


It is a process in which budget

is set and actual is compared with budget to analyse variances.

Budgetary Control


It means the establishment of

budgets relating the responsibilities of executives to the prerequisite of policy and the continuous evaluation of actual with budgeted results

Budgetary Control


either to secure by individual action the objective of that policy or to provide a base for its revision.


Objectives of Budget

Planning: A set of targets/goals is often

essential to lead and focus individual and group actions. Planning not only motivates the employees but also improves overall decision making.


Directing: Business is very complex and

requires more formal direction and coordination. Once the budgets are in place they can be used to direct and coordinate operations in order to achieve the stated targets.


Controlling: The actual performance can be

compared with the planned targets. This provides prompt feedback about performance. budget also prevents unplanned adhoc expenditure.


Advantages of Budgetary Control System

Enables the managers/ administrators to conduct activities in efficient manner.

Provides yardstick for measuring and evaluating the performance of individuals and their departments.


Reveals the deviations, from the budget by comparing with actuals; Helps in prompt review process

Creates suitable conditions for the implementation of standard costing system


Acts as systematic base for framing future policies and targets

Inculcates the feeling of cost consciousness and goal orientation

Leads to effective utilization of various resources, as the activities are planned and executed effectively.


Components of Budgetary Control System

The policy of a business for a defined period is represented by the master budget, the details of which are given in a number of individual budgets called functional budgets.


These functional budgets are broadly grouped as physical, cost and profit budgets.


Physical Budgets- Those budgets which contains information in terms of physical units about sales, production etc. for example, quantity of sales, quantity of production, inventories and manpower budgets are physical budgets.


Cost budgets- Budgets which provides cost information in respect of manufacturing, selling, administration etc. for example, manufacturing cost, selling cost, administration cost and research and development cost budgets are cost budgets.


Profit budgets- Budgets which enables in the ascertainment of profit, for example, sales budget, profit and loss budget, etc.


Fixed Budget Vs. Flexible Budget

Functional Vs. Master Budget

Long-Term Vs. Short-Term Budget/ Current Budget

ZBB

Types of Budget


A fixed budget is the budget

designed to remain unchanged irrespective of level of activity actually attained. Such budget is suitable for Fixed Expenses. It is also known as Static budget.

Fixed Budget


A fixed budget is not suitable in

dynamic environment and for a longer period because of its rigidity. It is not suitable where labour cost, material cost and other factors are constantly changing.


Flexible budget show the expected results of responsibility centre for several activity level. Flexible budget is the series of static budgets for different level of activity.

Flexible Budget


While preparing flexible budget the revenues and expenses are classified into Fixed, Variable and Semi-variable categories.


In most cases, the level of activity

during the period varies from period to period due to change in demand or seasonal nature or changing circumstances. In such industries/ government organisations flexible budget is suitable.


Budgets which relate to the

individual function/task in an organisation are known as Functional Budgets. For example, purchase budget, sales budget, production budget, plant utilization budget, cash budget.

Functional Budget


It is a consolidated summary of

the various functional budgets. It is based on goals set. It serves as the basis upon which budgeted P & L A/c and forecasted Balance Sheet are built up.

Master Budget


The budget which are prepared for

periods longer than a year are called long-term budget. Such budgets are helpful in business forecasting and strategic planning. E.g. Capital expenditure budget, Research and Development budget.

Long-Term Budget


Budgets which are prepared for

periods less than a year are known as short term budgets. E.g. Cash Budget. Such budgets are prepared regular comparison and action to bring variation under control.

Short-Term Budget


A budget which is established for use over a short period of time and is related to the current conditions is called current budget.

Current Budget


It refers to budgeting from scratch.

Zero Base Budgeting (ZBB)


ZBB is a method of budgeting

which requires each cost element to be specifically justified, as though the activities to which the budget relates were being undertaken for the first time.

ZBB


To receive funding during budgeting process, each activity must be justified in terms of continued usefulness.

Under ZBB, the budget for virtually every activity is initially set to zero.


Advantages

Provides a systematic approach for evaluation of different activities and ranks them in order of preference for allocation of scare resources.


Ensures that the every activity/ function undertaken is critical for the achievement of objectives.


Provides an opportunity to allocate resources for various activities / functions only after having a thorough cost benefit analysis.

Wasteful expenditure can be easily identified and eliminated.


Ex. Material purchase budget

Calculate the raw material required to be purchased:

Budgeted sales: 5000 units

stock of finished stock in hand is 500 units

Material A and B units (per finished stock unit) : 12 and 10 respectively


Opening stock of Raw material in

hand A: 5000 units B:3500 units Closing stock of 1000 units of finished goods and RM A and B, is required to maintain.


Solution

Budgeted Sales 5000

+ Desired Closing Stock 1000

Total Requirement of finished stock

6000

- Opening Stock (500)

Units to be produced 5500


Raw Material A B

5500 x 12 66000

5500 x 10 55000

- Opening Stock (5000) (3500)

+ Closing Stock +1000 +1000

Raw Material Purchase Budget 62000 52500

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Standard Costing and Variance Analysis

Dr. Varadraj Bapat

Module 15


Standard Costing

Definition

Steps in standard costing

Types of Standards

Variance

Types of variance

Variance Analysis

Advantages & disadvantages of Standard costing


Standard Costing

Standard cost is a pre-determined cost which is calculated from management’s standards of efficient operation and the relevant necessary expenditure. It may be used as a basis for price fixing and for cost control through variance analysis.


In simple words it is a budget for the production of one unit of product or service. It is chosen to serve as a benchmark in the budgetary control system.


Steps in Standard Costing

Study the actual cost

Cost variance Analysis

Set standard

Cost


Set the standard cost

A predetermined or standard cost per unit is set.

Budgeted cost determined by using standard cost.

•Study the actual cost

Calculate actual cost incurred in the production process


Cost variance

Comparison of the actual cost with the budgeted cost.

The cost variance is used in controlling cost.

Fix responsibilities to control cost

Take suitable action and create effective control system .


Types of standards

Ideal Standards: These represents the level of

performance attainable when prices for material and labour are most favorable, when the highest output is achieved with the best equipment and layout and when maximum efficiency in utilization of resources results in maximum output with minimum cost.


Normal Standards: These are the standards that may be achieved under normal operating conditions. The normal activity has been defined as number of standard hours which will produce normal efficiency sufficient goods to meet the average sales demand over a term of years.


Basic or Bogey standards: These standards are use only when they are likely to remain constant or unaltered over long period. According to this standard, a base year is chosen for comparison purposes in the same way as statistician use price indices. When basic standards are in use, variances are not calculated as the difference between standard and


actual cost. Instead, the actual cost is expressed as a percentage of basic cost.

Current Standard: These

standards reflect the management’s anticipation of what actual cost will be for the current period. These are the costs which the business will incur if the anticipated prices are


paid for goods and services and the usage corresponds to that believed to be necessary to produce the planned output.


Variance

The difference between standard cost and actual cost of the actual output is defined as Variance. A variance may be favourable or unfavourable. If the actual cost is less than the standard cost, the variance is favourable and if the actual cost is more than


the standard cost, the variance will be unfavourable. It is not enough to know the figures of these variances infact it is required to trace their origin and causes of occurrence for taking necessary remedial steps to reduce / eliminate them.


Controllable and uncontrollable Variance

The purpose of standard costing reports is to investigate the reasons for significant variances so as to identify the problems and take corrective action. Variances are broadly of two types, namely, controllable and uncontrollable.


Controllable variances are those which can be controlled by the departmental heads whereas uncontrollable variances are those which are beyond their control. If uncontrollable variances are of significant nature and are persistent, the standards may need revision.


Variance Analysis

Variance analysis is the analysis of the cost variance into its component parts with appropriate justification of such variances, so that we can approach for corrective measures.

Variances of Efficiency: Variance due to the effective or


ineffective use of material quantities, labour hours, once actual quantities are compared with predetermined standards.

Variances of Price Rates: Variances arising due to change

in unit material prices, standard labour hour rates and standard allowances for indirect costs.


Variances of Due to volume: Variance due to effect of

difference between actual activity and the level of activity assumed when the standard was set.


Analysis of Variance

Material Variance

Labour Variance

Overhead Variance

Sales Variance


Reasons of Material Variance

Change in Basic price

Fail to purchase anticipated standard quantities at appropriate price

Use of sub-standard material

Ineffective use of materials

Pilferage


Material Variance Material Cost Variance= (Standard

Quantity X Standard Price) –(Actual Quantity X Actual Price)

Material Price Variance= Actual Quantity (Standard Price - Actual Price)

Material Usage Variance=Standard Price (Standard Quantity - Actual Quantity)


Reasons of Labour Variance

Change in design and quality standard

Poor working conditions

Improper scheduling

Improper placement of labour

Increments / high labour wages

Overtime


Labour Variance

Labour Cost Variance=(Standard Hrs X Standard Rate Per Hour) –(Actual Hrs X Actual Rate Per Hour)

Labour Rate Variance=Actual Hrs (Standard Rate - Actual Rate)

Labour efficiency Variance= Standard Rate (Standard Hrs - Actual Hrs worked)

Idle Time Variance= Idle Hours X Standard Rate


Reasons of Overheads Variance

Improper planning

Under or over absorption of fixed overheads

Reduction of sales

Breakdowns

Power Failure


Variable Overheads (OH) Variance

Variable OH Cost Variance= (Standard Hrs X Standard Variable OH Rate) – Actual OH Cost

Variable OH Expenditure Variance= (Actual Hrs X Standard Variable OH Rate) – Actual OH Cost

Variable OH Efficiency Variance= (Standard Hrs - Actual Hrs) X Standard Variable OH Rate


Fixed Overheads (OH) Variance

Fixed OH Cost Variance= Absorbed OH – Actual Fixed OH Cost

Fixed OH Expenditure Variance= (Budgeted Hrs X Standard Fixed OH Rate) – Actual Fixed OH Cost

Fixed OH Volume Variance= (Standard Qty - Actual Qty) X Standard Fixed OH Rate


Reasons of Sales Variance

Change in price

Change in Market size

Change in Market share


Sales Variance

Sales Value Variance =

Budgeted Sales – Actual Sales

Sales Price Variance =

Actual Quantity (Actual Price - Budgeted Price)

Sales Volume Variance =

Budgeted Price (Actual Quantity - Budgeted Quantity)


Advantages & Disadvantages of Standard

costing Advantages

Basis for sensible cost comparisons

Employment of management by exception

Disadvantages Too

comprehensive to be useful

Precise estimation of prices or rate to paid is not possible


Means of performance evaluation for employees

Result in more stable product cost

May not be useful if frequent change in technology

Focus on cost minimization rather than quality or service.

Profit Planning, Activity-Based Budgeting, and e-Budgeting

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