PART 1 LESSON 2

BUDGETING METHODOLOGIES

LESSON 2 BUDGETING METHODOLOGIES

CONTENT
1. Budget Framework
2. Master Budget
3. Operating Budget
4. Financial Budget
5. Methods of preparing Budgets

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Budget Framework: An organization prepares budget for organization as a whole and

for each of its subunits. Budgets provide a framework of reference, a set of expectations
against which actual results can be compared. Organizations compare actual performance
with expectations and plan again after considering the feedback
Budget Framework

1. MASTER BUDGET: coordinates all the financial projections in the

organization’s individual budgets in a single organization wide budget. It
encompasses expectations from both operating decisions and financing decisions.
Operating decisions relate to acquisition and use of scarce resources. Financing
decisions center on how to get the funds to acquire resources. The term master in
“master budget” refers to it being a comprehensive, organization wide set of budget.

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An annual business plan or master budget called a summary budget is the formal budget
approved by the top management. Budget is classified based on capacity, coverage,
period or conditions. The following flow chart will give an idea.

Budgets

Capacity Coverage
Period Condition

Basic
Functional Master Short term Long term Current
Fixed Flexible budgets
budgets budgets budget budgets budget

The master budget gives a forecast profit & loss A/c and forecast B/S. The master
budget is a complete presentation of the operating plans of the entire company for the
relevant budget period. It is a basis for the successful financial planning and cost control.
In the master budget costs are classified and summarized by types of expenses as well as
by departments.
Thus the master budgets throw very useful information to the mgt. the master
budget often called summary budget represents a standard for the achievement of which
all the departments will work. In accounts closing the actual happenings are recorded
consolidated and summarized whereas in master budget the plans for the forthcoming
year are recorded. The master budget is backed by a number of functional budgets.

The steps involved in the development of master budget are given bellow.
 Preparation of functional budgets for the forthcoming period.
 Up and down adjustments to bring about harmony among different budgets.
 Preparative of summary budget.
 Budgeted P& L A/c.
 Budgeted Balance Sheet.
 Authentication of master budget by the BOD.

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The above steps may be represented in the form of a flowchart.

Organizational objectives

Short term plans or budget Long-term budgets

Cash flow budget

Budgeted profit & loss A/c

Budgeted balance sheet

Master budget

2. OPERATING BUDGETS:
i) Sales Budget (Revenue Budget): This provides the basis of all the other
budgets. It is the starting point for budgeting process. Sales budgets make forecasts.
Companies take into account past sales, sales trends, and general economic
conditions, political and legal considerations, planned advertising and product
promotion, and expected actions of firm’s competitors. This may involve high level
staff involved exclusively in forecasting.
ii) Production Budget: Based on sales forecasts production budget is prepared.
This budget plans for the number of units to be produced. The total number of units
to be produced depends upon the planned sales (Revenue budget) and the expected
changes in inventory level. When sales are not stable throughout the period the
managers must decide whether:

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(1) To adjust production levels periodically to minimize inventory held, or

(2) To maintain constant production level and let the inventory rise and fall
(3) Just in time production aims at keeping the inventory levels extremely low
by adjusting production
iii) Direct Materials usage Budget and Direct Materials Purchase Budget:
The number of units projected to be produced in the Production Budget is the key in
determining the Direct Materials usage in quantities and in dollars.
The following are the steps involved in the preparation of direct materials budget.
1. The standard requirement of each item of material was to be finalized. On
the basis of test runs and past performance the allowance for normal may be given.
2. The quantity standards should also be finalized. The standardization of
size colon and quality aspects would be as per requisite for finalizing the materials
budget.
3. The standard price for each item of material should be set. Finalizing the
after standards for quality quantity and price the material usage budget would be
prepared.
 The materials budget would show the quantity as well as cost each type of
direct material required.
 It also helps purchase schedule to avoid the situation of non-availability of
material.

Purchase budget:
It shows the quantity and amount of purchase to be made during the budgeted period. The
material budget shows the requirements of the organization during the budget period.
However for the preparation of purchase budget it is a pre-requisite to ascertain the
inventories to be maintained.
The purchase budget includes the cost of
1. direct materials
2. indirect materials
3. purchase of services
4. purchase of finished goods for resale

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The important consideration that govern the purchase budget are the following
1) Opening stock and closing stock of materials and components.
2) Storage space.
3) Re-order point
4) Safety stock
5) Economic order quantity
6) Seasonal discounts.
7) Finance planning.
The purchase manager responsible for the purchase budget should consider the trend in
prices and the different markets to finalize the best possible deal for the organization. An
example of a purchase budget is given bellow.

KSKS foundation Pvt Ltd

Direct materials purchase budget for the year ending March 31 2011

Material A Material
Desired closing stock 7000 4000
(units)
Add: units required for 160000 70000
167000 74000
production
9000 2000
158000 72000
Less: opening stock (units)
Rs 2 Rs 5
Unit price (Rs) 316000 360000
Purchase cost (in Rs)

iv) Direct Manufacturing Labor Budget: These costs depend on wage rates,
production methods, and hiring plans. The volume of production planned and the units
produced will be deciding factor in forecasting the direct manufacturing labor costs.

After the production budget and sales budget are settled the various machine operations
involved and services required can be arrived at the different grades of direct labor

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required to achieve the productions needs to be arrive at. Form the above the standard
hours required to complete the production can be arrived at. The standard rates of labor
can be ascertained and there by the total labor cost can be arrived at.

The benefits of labor cost budget are

1) The direct and indirect labor required to meet the production are defined.
2) The different grades of labor required as set out in the labor budget would indicate
the personnel department to plan the requirement and training of staff /
manpower.
3) The labor cost would indicate the management the finance required for meeting
the production plan.

An example of labor cost budget is given bellow:

Raman & co Pvt Ltd:
Direct labor cost budget for the year ending March 31 2011
Units to be Direct labor Total hrs Total labor cost
produced how per unit required @2 per hr
Product X 2000 6 12000 24000
Product Y 3000 7 21000 42000
Rs 66000

v) Manufacturing Overhead Budget: The total of these costs depends how overhead costs
vary with relevant cost driver. Different costing systems make different assumptions. For
instance under Activity Based Costing, overheads are estimated using activities as cost
drivers. In peanut butter type of costing, overheads are projected as a percentage of direct
labor costs. Direct labor hours may sometimes be assumed as a cost driver.
All expenses of indirect nature are covered under this lead variable overhead. It
comprises of indirect materials undirected labor and indirect expenses. The indirect
expenses include depreciation fringe benefits etc which helps us to find out the overhead
recovery rate. The manufacturing overheads are classified into fixed and variable
expenses. A careful study of the nature of expenses would be essential budget. The
preparation of fixed overhead budget is very simple and easy. The items normally

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included in the fixed overhead budget all property taxes depreciation rent fire insurance
etc. the variable overheads budget includes all indirect materials indirect labor and
indirect expenses which vary according to production.

An example of factory overhead budget is given bellow

ABC Company Ltd
Factory overhead budget for year ending 31.3.2011
(Anticipated activity of 120000 direct labor hrs)

Supplies Rs 10000
Indirect labor Rs 32000
Power (variable portions) Rs 30000
Maintenance cost (variable portion) Rs 14000
Total variable overheads Rs 86000
Deprecation Rs 35000
Property taxes Rs 4000
Property insurance Rs 2000
Supervision Rs 22000
Power (fixed portion) Rs 1500
Maintenance (fixed portion) Rs 5000
Rs 69500
Rs 155500

Factory overhead recovery rate is = 155500

1200000
= Rs 1.30 per direct labor hour

vi) Ending Inventory Budget: The Direct Material, Direct Labor and
Manufacturing Overhead Budgets result in computation of unit costs. The production
budget projects the ending inventory in units. The projected unit costs are applied to

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projected ending inventory units helps in calculating the costs of targeted ending
inventory.
vii) Other (Non production) Costs Budget (Selling and Administration Cost
budget): This projects costs in the areas of value chain other than production. This
includes projected costs for R & D, Marketing, Distribution, Customer service,
Administrative Costs. These costs may be broken up into fixed and variable portion.
Administration cost budget:
The expenses coming under administration cost are more or less fixed in nature. It
usually involves budgeting for top management functions like legal financial
accounting management information services audit and taxation these budgets are
prepared on pattern of fixed cost budgets.
Selling and distribution cost budget:
Selling costs are incurred for maintain the sales. After production the products have to
be sold to earn profits out of them.
The following items form part of the selling and distribution cost
i. Cost of creating demand & securing orders. The salespersons’ salaries
commission and traveling expenses would be covered under this.
ii. Sales promotion advertising etc.
iii. Cost of delivering orders: the costs of packing storage freight billing etc would
be included.
iv. Cost of credit and collection.
v. General sales office expenses.
vi. After sale services
vii. Market research
The selling costs are incurred to increase the volume of sales. A relationship between
the selling costs and to determined the amount of selling costs to be incurred to
achieve the desired volume of sales.
Distribution cost has been defined as the cost of the sequence of operations that begins
with making the packet of product available for dispatch and ends with making the re-
conditioned return of empty package if any available for re-use. It includes transport
cost storage and warehousing costs etc.

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Production cost budget:

The productions cost budget expenses the production units in money terms. It is a
summary of the material cost. Labor cost and overhead cost budgets. After preparing
the direct material, direct labor and overhead cost budget we can prepare the
production cost budget.
Cost of goods sold budgets (COGS Budget)
The COGS budget represents the cost of producing the products sold for a period this
budget is a summary of the production budget direct materials direct labor overhead
budgets and the cost of ending inventory of finished products.

An illustration of the cost of goods sold budget is given bellow.

Cost of goods sold budget for the year ending March 31.2011 of ABC LTD.

Amount (in Rs)

Direct materials used 420000
Direct labor 250000
Factory overhead 120000
Total manufacturing 790000
Add: finished goods (opening) 110000
Less: finished goods (closing) 80000
Total cost of goods sold 820000
If the adjustments for opening and closing stock of finished goods are given then it is
called production cost budget.

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The diagrammatic representation of short-term budgets is given bellow

Short-term plans or
budgets

Plant utilization

Productions
Direct material
budgets budget

Inventory Sales budget Direct labor

budgets budget

Manufacturing
Sales forecast overheads budgets
budget
Administration
Marketing overheads budgets
budget

Selling &
distribution
cost budget

3. FINANCIAL BUDGET: The financial budgets emphasize on obtaining funds

needed. A Financial Budget consists of
i) Pro forma Income Statement provides a budgeted Income statement using
budgeted operating budgets
ii) Capital budget
iii) Cash budget
iv) Pro forma balance sheet (based on capital budget and cash budget)
v) Pro forma statement of cash flows

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i) Pro forma (budgeted income statement):

The various parts of the operating budget are used to prepare a pro-forma income
statement. It will show the result of the operations at the end of the year. The result would
be profitable if the company meets its budget and if its assumptions prove to be correct.
However when the budgeted income falls short of the goal the management known it
must take corrective action. Therefore, for evaluating the performance a budgeted income
statement would act as a benchmarking.
An example of a Proforma income statement is given bellow.
Proforma income statement for the quarter earned March 2011 of XYZ co Ltd
Sales Rs 1000000
Less: cost of goods sold Rs 5300000
Rs 4700000
Less: selling & administration costs Rs 700000
Operating income Rs 4000000
Less: interest expenses Rs 1300000
Earning before taxes 2700000
Less: taxes 400000
Net income Rs 2300000

ii) Capital budget

Financing and investment are two important functions of financial management.
The investment of funds requires a number of crucial decisions to be taken in which
funds are invested and benefits are expected over a long period. The assets of a firm are
broadly the classified into fixed and current assets is known as capital budgeting. The
management is required to of a lot of crucial work like project planning commercial
evaluation of projects, feasibility study-technical and financial etc.

Meaning of capital budgeting

The term capital budgeting means planning for capital assets. It invested detailed
analysis as to whether or not money to be invested in long-term projects. Some examples

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are installing a machinery or setting-up of a factory or creating additional capacity etc. It

includes a financial analysis of various proposals and to choose one best out of the
available alternatives. The decision to invest in fixed assets is irreversible the decision
should be made very carefully. The capital budgeting decisions involve current outlays
but are likely to produce benefits over a long period.
Reasons for the importance of capital budgeting decisions
I. Heavy capital expenditure: as the very high decision has to b taken after careful
consideration the scarce resources available for an organization are to b utilized
effectively to produce profitable results.
II. Long time period: the capital budgeting decisions impact a long period of time. It
may even impact the growth and direction of the firm.
III. Irreversible: nature: once funds are committed to a capital asset it is very difficult
to reverse the decision.
IV. Complex decision: before deciding on the capital investment a lot of alternative
proposals are analyzed. It involves assessment of future events which may be very
difficult to predict. For all investment decisions a cost-benefit analysis has to be
made and in some cases it may be very difficult to quality the costs or benefits.
V. Implied sales forecast: the investment in fixed represents an implied forecast of
futures sales. Sometimes the investment of funds in plant and machinery very
much depends on the sales forecast for the next 10 to 15 years.
The long-term plans or budgets are represented below.

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Long-term plans or budgets

Capital budget

R & D budget

Manpower budget

Cap. Ex. Budget

Cap. Ex. means CAPITAL EXPENDITURE

iii) Cash budget:

It represents the cash requirements of the business during the budget period. It is a plan of
the receipts and payments for the budget period. Cash budget is a forecast of cash flows
built on certain assumptions and past patterns. The cash budget preparation should be
done in proper co-ordination with other functional budgets certain expenses like
employees on a regular basis. The preparation of cash budget is based on the following
information.
i. Daily estimate of cash receipts
ii. Daily estimate of cash disbursements
iii. Time-lay unused by credit transactions
iv. Time-lay in revenue & expenditure
The following are objectives of cash budget
i. The cash budgets would throw light on the cash position of the company so that
they can plan its purchases and avail the maximum possible discounts.

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ii. The forecast cash flow would also reveal the excess cash available & the
management may think of investing the excess cash in profitable avenues.
iii. The cash budget will have sum that the business proposes itself for additional
finance if required.
iv. It helps a great deal in planning the cash flows.
The cash budget is prepared by any one of the three methods
i. Receipts and payments method.
ii. Adjusted profit or loss account method.
iii. Balance sheet method.

Receipts and payment method:

It is a very simple method. All receipts and payments which are expected during the
period are covered under cash budget. Cash requirements of all the functional budgets are
taken into account. Moreover, adjustments are excluded.
An illustration is given bellow
Prepare a cash budget based on the following information
Cash on hand on 1.1.2010 is Rs 152000
Month Sales Materials Wages Production Selling &
&Administrative distribution
January 140000 45000 18000 16000 8000
February 188000 60000 23000 19000 12000
March 180000 55000 22000 16000 11000
April 195000 65000 25000 21000 13000
May 206000 75000 40000 25000 15000
June 220000 80000 45000 30000 16000
It is given that 50% are cash sales capital expenditure of Rs 20000 and 35000 is expected
in the month of February & April. A bank loan of Rs 70000 is expected in the month of
May. Debtors are accounted one month credit. A dividend of Rs 80000 is expected to be
paid during the month of June creditors grant one moth credit sales commission is @4%
of sales.
Solution: cash budget
Receipts

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January February March April May June

Opening balance 152000 174400 21188 279680 310380 326080
Cash sales 70000 94000 0 97500 103333 105000
Debtors cash 70000 90000 90000 97500 103000
bank loan 94000 70000
222000 164000 18400 187500 270500 208000
0 0
payments
material
45000 60000 55000 65000 75000
wages
18000 23000 22000 25000 40000 45000
production &
16000 19000 16000 21000 25000 30000
administration cost
selling distribution
80000 12000 11000 13000 15000 16000
cost
capital expenditure
120000 35000
dividend
80000
sales commission
5600 7520 7200 7800 8240 8800
47600 126510 11620 156800 153240 254800
closing balance 0
174400 200880 27968 310380 326080 279280
0

Adjusted profit & loss account is used as a basis for making the cash forecast. This
method works under the assumption that profit is equivalent to cash. The adjustment
made to the profit are added back of they don’t involve cash outflow. Some examples of
items added back to the profit are depreciation accrued expenses etc. the procedure for
preparation of cash budget from the profit & loss A/c is detailed bellow.
i. Cash balance at the beginning of the period.
ii. Net profit as reflected in the P&C A/C is added to the opening cash balance.
iii. Non-cash items like depreciation outstanding expenses are added to the profit.
iv. Capital receipts are added to the opening balance.

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v. Capital expenditure reduces the cost balance.

vi. Adjustments for current assets and current liabilities.

Balance sheet method

Under this method a forecast balance sheet is prepared considering the changes in all
items expect cash balance.

IV) Proforma (or budgeted) balance sheet

It is Proforma balance sheet prepared at the end of the budget period. The prior year
budget is taken as a base, changes effected in assets liabilities, and equity is incorporated
in the budget balance sheet.
The Proforma balance sheet is also called as budget balance sheet or statement of
financial position.

v) Proforma (or budgeted) statement of cash flows:

The Proforma statement of cash flows throws light on the projected source and uses of
funds. The Proforma statement of cash flow is prepared from Proforma income statement
and Proforma balance sheet the sources and uses of funds of the company reveal the
pattern of cash flows. The cash flow may be divided into three categories.
1) Operating activities.
2) Investing activities and
3) financing activities
The cash flows resulting from operations are categorized under operating cash flows. The
cash flows pertaining to buying and selling of assets come under the head investing
activities. The cash flows relating to repayment of debt repurchase of equity and cash
payments of dividend are covered under the head financing activities.

PROFORMA FINANCIAL STATEMENTS AND BUDGETS:

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The operating budgets and financial budgets together from the master budget. The
Proforma income statement is derived from the operating budgets. Based on the cash
budget and capital expenditure budget a Proforma balance sheet is prepared. In addition,
adjustment should be made in the Proforma balance sheet pertaining to retained earnings
after the dividend outgo is determined. From the Proforma income statement and
Proforma balance sheet, a Proforma statement of cash flows is prepared. The relationship
between Proforma financial statements and budgets are given bellow.

Sales budget COGS budget production

overhead budget administration cost
budget, selling & distribution budget

Budgeted (Proforma)
income statement

Capital budget Cash budget

Budgeted (Proforma)
balance sheet

Proforma (budgeted) Budgeted (Proforma)

income statement balance sheet

Budgeted (Proforma)
statement cash flows.

Creating a Proforma income statement with the percentage of sales method:

The process of preparing operating budgets and then to prepare Proforma
income statement is time consuming and tedious. Hence a short-cut approach known as
percentage of sales method is adopted. The percentage of sales method is a simple that
works on the assumptions that many of the items is the Proforma income statement and

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balance sheet and profit and cost A/c grow proportionally with the sales. All the
operating activities are assumed to grow in direct proportion with sales. None of the
financing activities grow proportionally with sales.

ASSESSING ANTICIPATED PERFORMANCE USING PROFORMA

FINANCIAL STATEMENTS
The main objective of preparing the Proforma financial statement is to compare them
with the predetermined financial targets. One of the ways of accomplishing the objective
is to calculating the financial ratios and compares them to per-determined targets and
industry averages.
The formula for calculating the financial ratios are given below.

1. Current ratio = Current assets

Current liabilities

2. Acid-test ratio (quick ratio) = (current assets – inventories)

Current liabilities

3. ROA (return on assets) = net income

Average total assets

4. ROE (return on equity) = net income

Average equity

5. Gross profit margin percentage = gross profit

Sales
6. Operating profit margin percentage = operating income
Sales
7. Net profit margin percentage = net income
Sales

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8. Debt total assets ratio = total debt

Total assets

9. Interest coverage or (times interest earned) = EBIT

Interest expenses
Where EBIT = earnings before interest and taxes.

10. Basic EPS earnings per share = (net income – preferred stock dividends)
Weighted average common stock share outstanding.

Illustration 1:
Given bellow are the balance sheets of A Ltd & B Ltd as on 31.3.2010.
Balance sheet
Liabilities A Ltd B Ltd Assets A B Ltd
Ltd
Equity shares 600 500 Fixed assets 850 930
9% preferences shares 150 100 Investments 120 250
Reserves & surplus Current assets
General Reserve 200 and loans and
P&L A/C 70 60 advantages
Secured loan Inventories 180 60
11% term loan 60 600 Sundry debtors 120 70
10% debenture 110 120 Cash & B/c 11 5
Unsecured loan Debtors 15 45
15% bank loan 25 35 Advances 200
18% short term loan 20 20
Current liabilities & provision
Sundry creditors 15 17
Outstanding expenses 6 3
Provisional taxes 40 5
1296 1460 1296 1460
Calculate the capital structure ratio

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i. owners equity = 750 600

Total equity 1296 1460

=0 .58 = 0.41

ii. debt = 195 755

Equity 750 600
= 0.26 = 1.26
Conclusion: B Ltd is highly leveraged in comparison to A Ltd. B Ltd is heavily
dependent on long-term debt. The leverage is favorable to equity shareholders if the rate
of return in higher than the rate of interest.

METHODS OF PREPARING BUDGET:

The following are various methods of preparing budgets
PROJECT BUDGET: Consists of costs expected to be attached to a particular project.
i) Project costs need to be tracked separately
ii) Project budgets must be in alignment with organization’s operations and
financial budgets
ACTIVITY BASED BUDGETING (ABB):
i) Applies activity based costing principles in budgeting
ii) Focuses on numerous activities necessary to produce and market goods and
services and requires analysis of cost drivers
iii) Budget line items are related to activities performed

ZERO BASED BUDGETING (ZBB):

A method of budgeting requires the managers of decision units to prepare a budget with
out any reference to the part budgets. It is an expenditure control device. The managers of
decision units have to justify each and every rupee proposed to be spent.

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In the words of peter. A. pyhm, “ZBB is an operating planning and budgeting process
which requires each manager to justify his entire budget requests in detail from
scratch. (Hence zero-base). Each manager has to justify why he should spend money
at all.”
It is a very challenging approach. The process is completely contradictory to traditional
budgeting. Traditional budgeting starts with a previous year expenditure as a base and
“cuts and additions” are made to the previous year budget. The cuts and additions are to
be justified before it is approved by the top mgt. In ZBB each business unit should
convince the top mgt regarding the budget allotment. Each business unit would be
subjected through analysis before approval. In ZBB the manger of each business unit has
to justify his entire budget in complete detail with a zero base. Each item of the budget is
analyzed and ranked in order of importance.

Features of ZBB:
1) The technique deals with all the elements of budget proposals.
2) Previous year’s budget or expenditure is not at all considered. Budget allotment is
made afresh and each units budget allocation is completely justified.
3) All the activities are broken up into decision packages
4) A critical evaluation of all the decision packages is made afresh.
5) The decision packages are ranked in the order of priority.
6) It provides the manager a combination of choices for arranging proposals.

Process of ZBB:
The following steps are involved in the ZBB.
(a) Determination of a set of objectives is an important per-requisite of ZBB.
(b) Identification of the decision packages or decision units.
(c) The decision packages are linked with the corporate objectives.
(d) The decision packages are valid and ranked in order of priority.
(e) The decision packages are translated into practicable units, items for allocating
financial resources and thereby a budget is prepared.

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Advantages of ZBB
1) ZBB is an extension of the cost benefit analysis to the area of corporate planning
and budgeting.
2) It provides a number of advantages to the organizational efficiency and
effectiveness.
3) It stresses that all spending in the organization is challenged.
4) The process of ZBB would highlight very useful facts of great importance to the
management.
5) It provides a systematic approach for the evaluation of different activities.
6) It compels the management to allocate the scarcer resource of the organization to
projects ranked in the order of importance.
7) It drivers the managers with the ability to innovate and analyzes can make
successful claims. The mangers should be self-driven to find out cost effective ways
to improve operations.
8) It is an effective managerial technique which sets out the best alternatives available
for a company.
9) The technique can also be used for the implementation of the system of
“management by objective”

Limitations of ZBB:
1) It is time consuming and costly. It needs properly trained managerial to do the
require job.
2) For implementing ZBB the companies have to do an exhaustive analysis of the
decision packages.
3) In ZBB the mangers have to justify their budgets in complete detail. Nothing is
taken for granted. The mangers have a tough task ahead of them.
4) For implementing ZBB the managers have to understand the techniques well to
successfully implement them.

FLEXIBLE BUDGETING:

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Flexible budget is designed to change in accordance with the level of activity

actually attained. A budget which by recognizing the difference in behavior between
fixed and variable costs in relation to changes in output, turnover or other variable factors
such as number of employees is designed to change appropriately with such fluctuations.
Flexible budget is also known as variable or sliding scale budget. The main feature of
flexible budget is that it gives expenditure at various levels of activity. For different
levels of activity we can extract the expenditure and compare it with the actual for better
performance. Flexible budgeting helps a great deal in performance evaluation. i.e. the
actual cost at actual activity is compared with eth budgeted thereby deviations are
analyzed and corrective action may be taken. Using the flexible budget methodology it is
possible to establish budgeted costs for any range of activity.
i. Fixed
ii. Variable.
iii. Semi variable.
Semi variable expenses are further segregated into fixed and variable expenses.
One of the important per-limitative of flexible budgeting is that the cost have to be
categorized into fixed variable and semi variable costs. In-depth cost analysis and cost
identification is required for the preparation flexible budget. Fixed items of expenditure
will be the same for all levels of activity. Expense of variable nature is identified and
variable cost per unit is determined. There by the cost is estimated for any level of
activity. For semi-variable expenses special efforts are to be taken to identify the same.

Steps in the preparation of flexible budget.

1. The budget is defined.
2. Cost categorization is done i.e. fixed variable and semi-variable costs.
3. Analyses the cost behavior patterns in response to past levels of activity.
4. Preparation of flexible budget for specified levels of activity.

Performance flexible budgeting

Practically there may be difference between the planned level of activity and actual; level
of activity. In such cases the budgeted costs at the actual level of activity are determined

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BUDGETING METHODOLOGIES

and compared with the actual costs. This information would help the management to
control the durations for ex. A business is expected to produce 100000 units during a
given period. The business actually produces only 800000 units. In such a case the budget
or profit plan for 100000 units would not be suitable. The budgeted costs for 800000
units would then be prepared and the actual costs would be compared with the budget.

Flexible budgeting illustration

1. A factory which expects to operate 70000 hrs at 70% level of activity furnishes details
of expenses as under:
Variable expenses = Rs 12600
Semi variable expenses = Rs 1200
Fixed expenses = Rs 18000
The semi-variable expenses go up by 10% between 85% and 95 % activity and by 0%
above 95% activity. Construct a flexible budget for 80, 90 and 100% activities.

Solution:
Head account 70% 80% 90% 100%
Budgeted hrs 70000 80000 90000 100000
Variable exp Rs 12600 Rs 14400 Rs 16200 Rs 18000
Semi variable exp Rs 12000 Rs 12000 Rs 13200 Rs 14400
Fixed exp Rs 18000 Rs18000 Rs18000 Rs 18000
Total exp 4260 44400 47400 50400
Recovery rate per hour 0.61 0.55 0.53 0.50

Conclusion: At 80% level of activity if the company has incurred an expenditure of Rs

45000 then it is concluded but over-spent by Rs 600.

2. A company produces product M and its sales at 80% capacity were at Rs 60000
Administration costs

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Office salaries = 9000

General expenses = 2% of sales
Depreciation = Rs 750
Rates & taxes = Rs 875
Selling costs salaries = 8% of sales
Traveling expenses = 2% of sales
Sales office expenses = 1% of sales
General expenses = 1% of sales
Distribution costs
Wages = Rs 1500
Rent = 1% of sales
Other expenses = 4% of sales
Draw up flexible administration selling and distribution costs budget operating at 90%
100% and 110% of normal capacity
Solution:
In the absence of important it has been assumed that the office salaries depreciation rates
taxes remain the same @ 110% capacity.

Flexible budget of product M

Expenses Basis Levels of capacity
80% 90% 100% 110%
Sales administration costs 60000 67500 75000 82500

Office salaries Fixed 9000 9000 9000 9000

General expenses 2% of sales 1200 1350 1500 1650

Depreciation Fixed 750 750 750 750

Rates & taxes Fixed 875 875 875 875

Total administration costs 11825 11975 12125 12275

Selling costs salaries 8% of sales 4800 5400 6000 6600
Traveling expenses 2% of sales 1200 1350 1500 1650
Sales office expenses 1% of sales 600 675 750 825

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General expenses 1% of sales 600 675 750 825

Total selling costs 7200 8100 9000 9900
Distribution costs
Wages Fixed 1500 1500 1500 1500
Rent 1% of sales 600 675 750 825
Other expenses 4% of sales 2400 2700 3000 3300
Total admin, selling & 23525 24950 26375 27800
distribution costs

CONTINUOUS (ROLLING) BUDGET:

Budget is revised on a regular (continuous) basis.
i) Budget is extended a month or a quarter based on additional data
ii) The advantage is that it requires managers to always think ahead
iii) But disadvantage is managers have to spend too much time on budget
preparation

INCREMENTAL BUDGETING:
 In this type of budgeting the prior year’s budget is taken as a base.
 It starts with a prior year’s budget and uses the projected changes in the costs and
sales and the adjustments are made to the prior year budget.
 The changes in the operating environment compared to the last year are also
adjusted in the prior year budget.
 The concept of incremental budget is exactly opposite of zero-base budgets.
 There is a possibility that the inefficiencies existed in the prior year my get carried
forward to the future years.
 It is also possible that some unnecessary expenses incurred in the prior year may
get approval the management and the middle level managers may take certain
approvals for granted.

KAIZEN BUDGETING
In Japanese, Kaizen means continuous improvement.

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i) It requires estimates of the improvements and costs for their implementation

ii) Kaizen is not based on existing system but on the changes to be made
iii) Budget targets are target costs. The target costs can be achieved through
improvements

STATIC BUDGET
It is based on one level of sales or production. This is in contrast with flexible budget
where series of budgets are prepared for many levels of activity
LIFE CYCLE BUDGET:
i) Estimates a product’s revenues and expenses over its entire life cycle
ii) Life cycle budgeting accounts for costs at every stage of value chain (R & D,
design, production, marketing, distribution, and customer service)
iii) Life cycle budgeting emphasizes the relationships among costs incurred at
different value chain stages
iv) Life cycle budgeting highlights the distinction between incurring cost s and
locking in costs
v) Life cycle concepts are also helpful in target costing and target pricing

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