UNIT 1: BUDGETING

Contents
1.0 Aims and Objectives
1.1 Introduction
1.2 Why Bother with Budget
1.3 Why Budgeting Gets a Bad Name
1.3.1 Time Taken
1.3.2 Lack of Top Management Commitment
1.3.3 A Form of Punishment
1.3.4 Responsibilities are Blurred
1.3.5 Moving Goalposts
1.3.6 Budgeting Rewards Inefficiency
1.4 Budgeting in Action the Abebe Trolley Company
1.4.1 Sales Budget for Year Ending March 31 1998 (Schedule 1)
1.4.2 Production Budget for Year Ending March 31, 1998 (Schedule 2)
1.4.3 Direct Material Budget for Year Ending March 31,1998 (Schedule 3)
1.4.4 Direct Labor Budget to Year Ending March 31,1998 (Schedule)
1.4.5 Manufacturing Overhead Budget for Year Ending March 31,1998(Schedule 5)
1.4.6 Selling & Administrative Budget for Year Ending March 31,1998(Schedule 6)
1.4.7 Closing Inventory Budget For Year Ending March 31,1998 (Schedule 7)
1.4.8 Cash Budget For Year Ending March 31, 1998 (Schedule 8)
1.4.9 Budgeted Profit And Loss Statement (Schedule 9)
1.4.10 Budgeted Balance Sheet for Year Ending March 31,1998 (Schedule 10)
1.5 Discretionary Expenditure and Zero Base Budgeting
1.6 Summary
1.7 Answers to Check Your Progress
1.8 Model Examination Questions

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1.0 AIMS AND OBJECTIVES

After completing this unit, you should understand:

 the role played by budgets in an organization
 the problems surrounding budgets and how to solve these problems
 the techniques of preparing a master budget and supporting schedules;
 the nature of discretionary expenditure and how zero-bas budgeting can assist in
allocating resources.

1.1. INTRODUCTION

Through out this course the focus of attention has been on interpreting accenting numbers,
which have been generated by the underlying cost gathering and allocating systems. We have
considered how costs behave (variable or fixed, traceable or common, and so on), how these
costs can be combined to yield useful managerial information such as break-even points and
contribution margins, the problems of allocating common costs to individual jobs and process,
and requirement to identify only relevant costs for decision making. In the first part of financial
accounting we considered the arrangement of accounting numbers into financial statements for
use by people external to the organization. Little space has been devoted so far to predicting the
accounting number, which will emerge from the systems in place.

This predictive step in the management process we call budgeting; it will be the subject of this
unit and the next. Management must give thought to the future in order to plan to meet its
threats and opportunities. Without this planning the business will move up and down like a cork
in a turbulent sea, without direction or purpose. This unit will set out the procedures for
construction the budget and the next unit will conceder the mechanism available to
management to monitor the actual performance against the plan.

A word of comfort for those readers who have perhaps glanced at the contents of the unit only
to see pages comprising tables of numbers: budgeting is the most intuitively straightforward
topic covered by this course. It is a discipline practiced by each one of us each week, month or
year as we set out to match our income from whatever source against outlay .The signals that
we receive from such an exercise- usually danger signals as we realize that outlay will exceed

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income lead to some form of corrective action which is designed to prevent us from becoming
bankrupt. These personal procedures are automatic, business environment without undue
difficulty.

1.2 WHY BOTHR WITH BUDGETS?

BUDGETS?

Business is made up of people, large numbers of people, all doing a job which they regard as
being a useful contribution to the well-being of the business that employs them. But people are
not automations, programmed to carry out every task in a prescribed manner at a given time
and location. Each of us tends to have an unshakeable confidence in our own judgment and
sense of property; each of us prefers to work at our own pace. But without a coherent plan to
work towards, this rich mixture in personal behavior is a recipe for disaster, for no two
individuals share the same values, or view the world in the same way or work towards the same
goal at the same pace. Employee’s efforts and motivation need to be harnessed, directed and
controlled. The budgeting process should help to achieve the budgeting then has the following
attributes.

Coordination:
Coordination: it co-ordinates activities within the same organization. The budget will identify
whether the aspiration of the sales team can be realize by the production department or whether
these should be trimmed in order to match the limited output resources of production; the
budget will permit a recruitment program of scientist or engineers to be put in place so that the
R&D activities can be moved forward to ensure a healthy supply of innovative products; the
budget will flush out surplus resources being devoted to marketing and promotional activities
in the light of reduced sales targets.

Planning: it encourages planning. Without some idea of where the organization is heading,
managers have no concept of resource requirements nor can they form a view on the actual
performance of the business month-by-month, year by year. A detailed plan set out the targets
for the entire organization to aim for. The sales plan will merge production; capital investment
decisions will be phased to be aligned with new product launches and cash availability; raw
material purchases and recruitment of workforce personnel will be geared to production
requirements. By planning, the forceful, megalomaniac of one senior official is counted by the
pragmatic realism of the marketplace. For example, a proposed twofold increase in the

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marketing budget for next year may not be sanctioned if sales targets are under pressure due to
overseas completion or perceived quality issues. An investment in replacement production
equipment may be prevented if new generation of products will require different facilities.

Motivation:
Motivation: it promotes motivation. Once the business’s budget is broken down into its
constituent parts, individual departmental heads obtain a clear picture of the route ahead for the
next period, usually a year. By further subdivision, each person in the organization has a target
to shoot at which, provided it has been set within achievable limits, will provide a personal
motivation throughout the period. Without this motivation, performance is likely to be
uninspiring and the organization will lose its competitive edge.

Control: it provides a control benchmark against which to measure actual performance.

Without a budget mangers do not know how well their departments have done; they are like
athletes in training without a stopwatch – they think they are performing satisfactorily but have
no way of confirming this. Only through a careful analysis of actual performance will managers
and their colleagues be able to amend the next budget to make the target tough but achievable,
and worth achieving.

A budget, then, is a plan of action, usually expressed in numbers and amounts, which sets
targets for individuals and for the business over a defined future time-frame. But note that a
budget is only a numerical expression of a plan, it in not a plan itself. Planning of a business’s
future, sometimes referred to as strategic planning, must precede the budget exercise. Strategic
planning is the managerial exercise which attempts to ensure that a business accomplishes a
sufficient process of innovation and change by allocation scarce resources (cash, critical
management talent and technological know-how) by adapting to environmental opportunities
and threats and by co-coordinating activates so as to reflect the business’s strengths and
weaknesses.

1.3 WHY BUDGETING GETS A BAD NAME?

Given the positive attributes of budgeting which have so far been described, why is it the word
budget or budgeting arouse so many negative and hostile reactions by those in businesses who
are meant to drive benefit from the process?

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We suggest below a few of the reasons, which must be overcome if the business is to use
budgets as a significant management tool.

1.3.1 Time Taken

As a company grows in size so too do the budget problems. To enable the new financial year to
start with the budget having been agreed and communicated to all participants, corporate
headquarters often start the process before the current financial year is six month old. The
reasons for this early start are clear to Head quarter but may not be clear to managers and
departmental heads working far removed from the center. A good budget process is an iterative
one where first thoughts (on sales or production or staffing levels or new markets) need to be
amended by other manager’s first thoughts. To allow for second, third, and fourth thoughts time
is needed, so that these can be co-ordinate and formulated into a cohesive plan. Face-to-face
meetings and budget conferences toward the end of the planning period must be arranged for
the key players; to allow for the circulation of meaningful figures time must be set aside. The
demoralizing feature of the length of time involved is caused by managers not knowing how
the current year is panning out (i.e how accurate last years budget is proving to be) before being
asked for an assessment of next year. There can be no firmer basis for next year than what
happens this year. There can be no firmer basis for next year than what happens this year; if this
year is only a matter of a few months old, managers will disregard the early steps in the process
and supply unsubstantiated guesses which will require amendments as the year progress,
thereby undoing the advantage of an early start. The budget process should start as late as
possible in the current year consistent with getting agreement by the start of the New Year.

1.3.2 Lack of top Managements Commitment

Budget holders, that is managers and departmental heads in the operating divisions removed for
head office, very often resent the effort and self-control required of them as individuals to keep
within the budget only to see apparent profligate spending on the part of senior management
personnel. Their suspicion is that either this leveled spending is not required to carry out the
functions of the individuals involved or that the spending continues to be incurred even after
the budgeted resources given over to that activity have been consumed. A less-than-
professional approach to their own responsibilities by top management will ultimately lead to a
breakdown of the budget process where managers do whatever pleases them, disregarding

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previously agreed targets and limits. Only if the whole management team shares the ideal of
constant improvement in operating performances will the commitment of lower-level staff be
ensured.

1.3.3 A Form of Punishment

Too often managers regard budgets as a form of thumb-screw torture practiced by the top
echelon of a company. Budgets, in this context, are seen to be for control purposes only,
devices for screwing down activities (and individuals) to the absolute minimum amount of
resources required to do a mediocre job; all discretionary expenditure such as entertaining and
travel are stripped out, surplus staff are removed and the remainder required to work in sweat-
shop condition! If this perception of budgets is widespread top management deserves to be
removed for office. Budgets are the principal vehicle for planning and decontrol in an
organization. Planning requires consultation and co-ordination with those employees who will
be required to implement the budget and by consultation we mean listening and acting upon
advice rather than a cynical process of seeking advice then ignoring it to – management can
guarantee support of those managers who had a hand in the construction of the budget. These
manager will feel as if the own part of the budget which will in turn generate a pride in
performance and achievement in meeting the targets set.

1.3.4 Responsibilities are Blurred:

Budgets are a means whereby all cost and revenues are planned for over the next accounting
period. Managers in operating divisions are happy to be held responsible for those costs and
revenues over which they have no control whatsoever, are allocated to them. Examples of such
costs would be group-wide marketing and promotional activities, executive salaries and other
expenses such as the corporate fleet of aircraft, and centrally located research and development
laboratories. Necessary as most of these heads of expenditure are deemed to be, it is unfair and
de motivating to lower-level budget holders to assess their performance on managing the
unmanageable. corporate expenditure should be allocated on a budget holder who can be held
responsible-even if this is the chairman or chief executive. A budget holder should have
responsibility only over controllable costs and controllable revenues.
1.3.5 Moving Goalposts

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Another complaint often leveled at the budget process by managers is that circumstances can
change early in the year that can invalidate the premises and numbers which were so carefully
prepared a few month earlier. They complain that if their numbers are not updated in the light
of the changed circumstances (e.g. the collapse of a major customer or supplier), the resultant
comparisons with actual performance are meaningless. Equally, should the budget be adjusted
to reflect extraneous factors –some times several times during the year-the initial effort which
was invested in the preparation of the original figures is seen to be misplaced. Companies can
avoid these managerial misgivings in one of two ways.
1. They can adopt a rigid view towards the original budget. Regardless of environmental
disturbance the original numbers remain the benchmark against which subsequent
performance will be measured. But in reporting variances between actual and budget, the
accounting staff first strip out the variance caused by the external event before
highlighting those variances which can viewed as the responsibility of the managers
involved. In this way the manager’s performance is assessed on the up-to-date expectation
but the company does not lose sight of the original view of the future as represented by
the beginning -of –year budget. After all, it may be argued that careful analysis in the first
instance should have predicted the extraneous events. If this is the view then the budget
process needs to be tightened up the following year.
2. They can implement a rolling budget whereby, as the current month expires, another
month is added on to the budget 12 months away. In this way the budget is always a 12-
months view of the future and can be amended as soon as disturbing events become
known.
Both of these methods have the advantage of maintaining the integrity of the budget process by
signaling to the mangers that their investment of effort in preparation will be rewarded by
reporting visibility.

1.3.6 Budgeting Rewards Inefficiency

Underpinning the accusation that budgeting reward inefficiency is the notion that costs and
revenues are very often budgeted to increase by a constant percentage, say 10, percent.

Check Your Progress –1

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1. What is budgeting?
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2. Why budget gets a bad name explain
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Budget controller to production director:

director:
We want to boost sales by 10 per cent next year. Work out your production budget accordingly
and let us known what extra resources you will need.
Or
Chief executive to marketing manger:
If we were to increase your budget by 10 per cent next year, what would you do with the extra
resources-people or promotion?

This approach to budget uplifts-all too common in the non-public sector, particularly in
companies, which have had a track record of satisfactory profit-, irritates many managers who
regard it as a technique for rewarding inefficiency. They argue that departments or divisions,
which have allowed slackness to creep into their operating procedures, will be given additional
percentage uplift on this element of slackness. This will result in even more corporate resources
being squandered by these departments. And of course the tightly run, well-managed
departments are penalized accordingly. Similarly if the blanket percentage adjustment is
downwards; the inefficient department is only asked to cope with a reduction in resources
which may not even remove all the inefficiencies while the efficient departments must make
substantive cuts which will have a negative effect on their ability to deliver a quality service.

Driving out inefficiencies from budgets is one of the most difficult managerial tasks,
particularly in areas where the benchmarks of performance are unclear and ill defined, ex.
research and development laboratories, marketing and administration, including personnel and
legal services. We call these discretionary costs, which can be contrasted with engineered costs-

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which are those costs directly associated with the products or services being made. A company
making cabinets knows how much to expect by way of material costs, labor costs and energy
cost but it does not really know how much it should spend on its personnel department. We will
consider the problems caused by discretionary costs in a letter section. Top management must
adopt an altogether tougher and more rigorous approach to budget uplifts and cuts than the
blanket percentage method.

It should encourage computation for surplus resources within the organization while, at the
same time, not recoiling from taking allocation decisions even if these are based on nothing
more substantial then intuition and gut-fell where the competitive claims are broadly similar in
financial terms.

1.4 BUDGETING IN ACTION: THE ABEBE TROLLEY COMPANY

Instead of setting out the steps for the preparation of a budget in a sequential and theoretical
manner removed from any commercial context, let us use the case of a successful company,
which has completed its financial year to march 31,31,1997 and is planning for the next 12
months. Clearly the exercise would commence several months before the year-enc but so that
we can use figures from the end-of –year balance sheet for the next year’s budget we imagine
that what follows transpires over the space of a few days at the end of March 1997.

Abebe Trolley Company manufactures and sells a much sought-after product, a supermarket
trolley that can be pushed by the customer without effort and in a straight line. The special
wheels and bearings, which permit such easy motion, are the result of careful research over the
past three years of the company’s trading history. The management of the company is keen to
grow slowly without overreaching the company’s resources; the managers have read too many
stores of similar sized companies expanding too quickly with borrowed money only to go into
liquidation when the market turned against them, and they are determined to avoid such a fate.

At the outset of the budget process the chief executive would issue general guidelines to the
principal head of departments. In a larger organization a more formal budget committee may be
convened, chaired by the chief executive, to mastermind the whole process. Such a committee
would comprise the key players in the organization, the production director, sales director,

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finance director and personnel director, together with their respective chief operating officers.
The financial controller would probably be appointed budget officer whose task it would be to
drive the exercise forward to final approval by the budget committee on behalf of the board of
directors.

The guidelines would contain a commentary by the chief executive on the year just finishing,
reasons of the superior (or inferior) performance against budget, his view on the potential for
growth a report on the expected product launches in the forthcoming year, the relevant
economic indicator to the business (in the case of the Abebe trolley company these would
include indicators of consumer spending, rate of construction of supermarkets and shopping
centers and expenditure patterns). But most significant of all would be the chief executives
view on growth. He or she is the best placed person to weigh the potential for growth in output
against the company’s ability to support this growth from its own resources for from
borrowings. It would be futile for lower level manages to budget for a much higher rate of
expansion than the chief executive considered prudent. An assessment of expected earnings per
share may also be given.

The chief executives report may look like this:

Memorandum from chief executives

To all functional managers: budget preparation for year march 31, 1998

As a background to the forthcoming budget process I should like to sketch in a few indicators,
which I should like you all to keep in mind in the next few weeks as we work towards closure
on the budget for year ending 31,3.98.

The final un audited figures for the year ended 31,3,97 will reveal a healthy profit and a strong
balance sheet which is reproduced below:

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Abebe trolley company
Balance sheet
March 31, 1997
Current asset
Cash -----------------------$17,500
Debtors------------------------7,500
Finished goods--------------26,400
Row material inventory---------600
inventory---------600
Total current asset 52,000
Plant asset
Plant and equipment--$75,000
Less. Accum.dep--------(25,000
Accum.dep--------(25,000)) 50,000
Total assets---------------------------102,000
assets---------------------------102,000

Liability
Creditors--------------------------------$2,500

Owners equity
Share capital-----------30,000
Retained earrings-------69,500 99,500
Total liability and owners equity-----102,000

This performance is a tribute to our carefully targeted growth in specialized sectors of the
market, together with the ongoing good work of our Research and Development engineers in
keeping our product technologically superior.

But there is still reluctance on the part of many supermarket chains to buy
the product due to its relatively high cost of $65. This is some 30 per cent higher
than our nearest competitor and although they recognize the advantages of trolleys which move
without steering effort they nevertheless are prepared to purchase inferior products. Eventually
consumer pressure will make them change over to our product but I do not want us to
contemplate a drop in either price or quality.

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Quite the reverse, I want us to consider a modest increase in price in order that we retain the
image of quality and service, which sets us apart from the completion.

I know many of you want to expand production so that we can attack other markets such as
airports, coach stations and rail stations. We have commissioned a marketing study on such
possibilities, which will not be a available before e September.

I therefore want you to consider only a modest increase in units sold this year. It is far better
that we build a secure platform for growth both in terms of market share and financial
soundness’ rather than charge ahead for new sales just to improve our turnover ratios.

The economic indicators that I have studied indicate a slowing down in consumer spending
next year. The continued high interest rates are having an effect on disposable income;;
therefore we can expect fewer orders from the electrical stores and furnishing outlets. A modest
growth in household spending stores (grocery stores and the like) can be expected. And the
much heralded developments in Addis Ababa city center for shopping have not yet
materialized. We can expect some movement in 1999.

One final work: I have detected some resentment among some of you bout the high level of
spending on Research and Development engineering. Those who harbors such feelings should
remember that our company’s history is based on a unique design of wheel and bearing. Had it
not been for our early investment in research and development we would not be working for
this company today. We must keep ourselves technologically in the forefront. The chief
engineer is currently working on a device which save the customer and check-out operator from
having to unload and reload the trolley at the check-out operator from having to unload and
reload the trolley at the check-out. The designs are still in their infancy but we anticipate
significant demand for this if we can be first-to-market. But this design and prototype stage
costs money. So I want to allocate 3 percent of sales revenue to research and development
those of you who complain at such expense should contemplate the future for this company
when our competitors catch up with us and we have nothing new to offer the market.

Please let the financial controller have your fist thoughts on next years budget by the end of the
week. We can then have a meeting to iron out different views and go firm on the number by
April 1.

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The sales team would be called together by the sale director to plan their numbers for he
following year:
Sales director: you have all received a copy of the bosses guidelines. I am a little disappointed
at the request to raise prices because even at $65 some of our principal customers were
complaining.

Sales district manager:” but not all of them! Wizero embet expressed surprise to me that in
their latest order, trolleys were invoiced at $ 65. as we had held our prices stable for nine
months they were expecting –and I suggest would not have complained at –a price rise. $70 per
trolley would be the figure which I think could be accepted by our customers. This would be a
7.6percent rise against 3F and 12 percent rise against Tekur Abaye.

Sales director: Ok, $70 seems reasonable but we may have to be prepared to discount this to
some of our large customers who show reluctance. But I don’t think we should flag this up in
the budget because it is not going to be a big amount. Now what about the quarter-by-quarter
sales profile?

Sales executive: I have done some preliminary figures at $70 per trolley which have been
based on this years profile and I have allowed for a 5 percent increase in sales units due to the
impact of our new advertising material. Hear are my numbers:

quarter estimated sales units

1. to 30 June 1997------------------------------2500
2. to 30 September 1997-----------------------2800
3. to 31 December-------------------------------1700
4. to 31 march 1998-----------------------------3000
5. to 30 June 1998--------------------------------3000
‘the anticipated drop in units in quarter 3 follows the trend in previous years. As our customers
are stocking up for Christmas their cash flow prevents any significant outlay on such items as
trolleys. But after Christmas we can expect a replacement program to be embarked on and for
this to be carried forward, to be embarked on and for this to be carried forward, together with
new business, into the fist quarter of next year.’

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Advertising manger: ‘I really think we want to step up the spend on advertising this year. I
agree that the current campaign is having an effect although we were taking a risk in portraying
a housewife being pained against a freezer by one of our competitors’ trolleys. I should like to
argue for similar funding to Research and Development, say, a 5 percent spend linked to sales
revenue in addition to the $3000 per quarter fixed salaries.

The production team would have a similar meeting:

Production director: ‘given the chief executives view on not wanting to rise up production next
year in advance of sales I suspect we should examine the sales teams view on units to be sold
and cost our production activity on these’.

Production controller: ‘a work of caution here. Our suppliers are still fairly erratic despite our
best efforts to signal demand to them in plenty of time. I should like to argue for having raw
material inventories on hand equivalent to 10 percent of next quarter’s requirement. And
another thing, despite these apparently well thought out sales figures, the sales people always
wanting rush orders put through because they have messed up their forecasting. From the
experience of this year I think we should have finished goods inventory equal to 20 percent of
expected sales new quarter.’

Purchasing officer: ‘the price of wire metal will go up midway through the year but I have
negotiated a 12 month purchasing bulk discount with our principal suppliers. So the cost per
meter will be $1 on average for next year.’

Production controller: the cost per for our skilled labor will increase marginally but I
anticipate this will be offset by increased speed of operations due to the new equipment we
purchased last year. All in all the variable costs and fixed costs should look like this

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 Per trolley
Direct material $
10 meters of wire metal at $1 per meter------10
direct labor
1.5 hours at $20 per hour-------------------------30
variable overhead (absorbed by direct
labor hors)
1.5 hours at $10 per hour -------------------------15
-------------------------15
variable cost per trolley-------------------------- 55
fixed manufacturing overhead-----------------$2400
(includes depreciation on plant and
equipment)-----------------------------------------$1500
consumables--------------------------------------$2000

the finance and administration team would also discuss the forthcoming year:
financial controller: ‘we must attempt to tighten up on debtors collection next year. We should
plan for 70 percent of sales being collected in the quarter of sales with the balance being
collected in the next quarter. Yet again we had no bad debts this year due to the quality
customers our sales team is targeting, so we should not predict any for next year’

financial director: ‘we should be careful then about not paying our creditors too quickly. I
suggest that raw material purchases should be paid for 60 percent in the quarter of purchase and
40 percent in the next quarter. All other selling, advertising and administration costs, including
administrative salaries of $2000, will be paid for, as usual, in the quarter they are incurred.’

These reports and supporting schedules would be submitted to the financial controller whose
task it would be to draw up the company’s master budget for the year to march 31,1998. This
master budget would comprise the build-up schedules from production and sales and culminate
in the budgeted cash flow statement for the year together with the budgeted profit and loss
account and balance sheet.

[Readers should carefully follow each of the schedules set out in the next few pages, tracing the
numbers back into the data given above and following the calculation given below each

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schedule. Not only is this an exercise in financial accounting again the fulcrum on the entire
budget is balanced is the sales budget. Without sales the company’s other functions are
superfluous. It is important not only to track the profile of sales but to convert these sales which
would appear in the financial accounts into cash receipts.

1.4.1 Sales Budget for Year Ending March 31, 1998 (Schedule 1)

a, Q1 Q2 Q3 Q4 total
turnover in units---------2500 2800 1700 3000 10,000
price-----------------------*$70 *$70 *$70 *$70 *$70
recorded sales -------$175,000 $196,000 $119,000 $210,000 $700,000

b.cash inflow from sales

Last quarters collection---$7500 $52,500 $58,800 $35,700 $154,500
This quarters collection---122,000
collection---122,000 137,200
137,200 83,300 147,000 490,000
$130,000 $189,700 $142,100 $182,700 $644,500

The upper schedule sets out the sales turnover figures as they would appear in the financial
accounts of the ABEBE Trolley company. Readers will remember from their study of the first
seven modules in this text that accountants are prepared to record sales even though the cash
has not been received provided all effort has been completed and that there is no evidence to
suggest that customer will default. Therefore in the budgeted profit and loss account for the
year march 31, 1998 the turnover will be given as $700,000.

1.4.2 Production Budget for Year Ending March 31, 1998 (Schedule 2)

Q1 Q2 Q3 Q4 total
Sales units 2500 2800 1700 3000 10,000
Add: planned unit in
Closing inventory ----------560
----------560 340 600 600 600
3060 3140 2300 3600 10600
Less: units in opening
Inventory 480 560 340 600 480
Units required-------------2580 2580 1960 3000 10,120

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The sale targets of schedule 1 would then be converted into production numbers which would
take account of the production controllers observation that inventory of finished units should be
carried to meet the uncertainties of demand. To the planned sales units is added the
requirement to hold 20 percent of next quarters sales. For Quarter 1 this amounts to 20 percent
times Q2s 2800 units = 560; therefore in Q1 3060 units should be manufactured. But the
opening balance of inventory of finished units would reduce this requirement. We learn from
opening balance sheet that 480 units were in inventory at the beginning of Q1; therefore only
2580 units need be made in Q1.

The production unit’s budget must now be converted into a cost budget, comprising direct
materials, direct labor and manufacturing overhead. There are three components to the direct
materials budget, the consumption of metal, the purchases required to meet the production
schedule, and the payment to creditors profile.

1.4.3 Direct Materials Budget for Year Ending March 31, March 1998 (Schedule 3)

A, Consumption of Direct Material

Q1 Q2 Q3 Q4 total
Units required------------------2580 2580 1960 3000 10,120
Direct materials
Meters of Metal 10 10 10 10 10
Meters of metal required---25800 25800 19600 30000 101200
Cost per mater--------------- $1 $1 $1 $1 $1
Total cost of metal
Consumed------------------- $25800 $25800 $19600 $30000 $101200

This schedule is self-explanatory, being based on the production schedule just calculated. This
profile would allow for a rise in price to be recorded midway through the budget year if
necessary.

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B, Purchases Budget
Dirct materials required
(in meters) ---------------- 25800 25800 19600 30000 101200
Add: planned closing
Inventory------------------2580
Inventory------------------2580 1960 3000 3000 3000
28380 27760 22600 33000 104200
Less: planned opening
Inventory----------------- 600 2580 1960 3000 600
Materials required-------27,780 25180 20640 30000 103600
Cost per metre---------------$1
metre---------------$1 $1 $1 $1 $1
Total cost of metal
Purchased ----------------$27780
----------------$27780 $25180 $20640 $30000 $103600

The starting point for the purchases budget is the number of meters of metal required to
manufacture the units to be made (from schedule 2). But again the production controllers
wishes for inventory must be built in to the figures; this time 10 percent of the next quarters
production must be added to this quarters requirements but the opening inventory balance
reduces the meters of metal which need to be purchased. And again Q1s’ opening inventory
figure of 600 meters is taken from the closing balance sheet as at march 31,1997. Note that we
have assumed that the desired closing direct material inventory for Q4 is planned to be the
same as at the end of Q3.

C, Cash Outflow for Purchase

Q1 Q2 Q3 Q4 total
Creditors end 1997---- $2500 $2500
Purchases:--------Q1 16,668 $11,112 $27,780
Q2 15,108 $10,072 $25,180
Q3 12,384 $8256 $20,640
Q4 18,000 $18,000
$19,168
$19,168 $26,220 $22,456 $26,256 $94,100

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Readers will notice that the total column in this schedule bears a resemblance to the quarter-by-
quarter profile in the previous one. The cash outflow schedule splits up the purchase budget
into the quarters, which match the cash payments. In Q1, for example, the company will pay
outstanding creditors from the end of last year, $2500 (see closing balance sheet), and 60
percent of $27,780 purchases made in Q1.the balance of Q1s’ purchas,$11,112 will be paid for
in Q2. Q4s purchase of $30,000will be paid for: $18,000 in Q4 and $12,000 in next years Q1.
therefore creditors at the end of the year will be $12,000.

The direct labor budget presents no difficulties because labor cannot be inventoried. Schedule 4
is based on the production units calculated in schedule2.

1.4.4 Direct Labor Budget for Year Ending March 31, 1998 (Schedule 4)

Q1 Q2 Q3 Q4 total
Units required------2580 2580 1960 3000 10120
Hours per unit------ 1.5 1.5 1.5 1.5 1.5
Total no of
Labor hours 3870 3870 2940 4500 15180
Cost per hour------ $20 $20 $20 $20 $20
Total cost of
Direct labor------$77,400
labor------$77,400 $77,400 $58,800 $90,000 $303,606

The actual cash outlays for labor will match exactly the calculations of this schedule.
The manufacturing overhead budget is equally straightforward except that (a) variable and
fixed overhead are kept separate, and (b) the depreciation element of the fixed manufacturing
overhead is deducted from the total manufacturing overhead to give a final figure which
represents the quarterly outflow of cash for overheads.

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1.4.5 Manufacturing Overhead Budget for Year End March 31, 1998 (Schedule 5)

Q1 Q2 Q3 Q4 total
Total cost of direct
Labor--------------$77,400 $77,400 $58,800 $90,000 $303,600
Absorption rate
For variable overhead---$.50 $.50 $.50 $.50 $.50
Variable overhead---$38,700 $38,700 $29,400 $45,000 $151,800
Fixed overhead --------2400 2400 2400 2400 9600
Total manufacturing
Overhead ------------$41,100 $41,100 $31,800 $47,400 $161,400
Less: depreciation-----
depreciation----- 1500 1500 1,500 1,500 6000
$36,600
$36,600 $39,600 $30300 $45,900 $155,400
Management would expect a detailed analysis of variable and fixed overhead and would not
accept the formula of 50 percent of direct labor cost (for $10 per direct labor hour) without
such an analysis.

1.4.6 Selling and Administrative Budget for Year Ending March 31, 1998 (Schedule 6)

Q1 Q2 Q3 Q4 TOTAL
Total sales------$175,000 $196,000 $119,000 $210,000 $700,000
Selling and admin
Variable
Advertising 5% $8750 $9800 $5950 $10500 $35,000
R&D 3%-----------5250 5880 3570 6300 21000
Fixed
- salaries 2000 2000 2000 2000 8000
- consumables 2000 2000 2000 2000 8000
- advertising 3000 3000 3000 3000 12000
total selling and
admin ------------ $21,000
$21,000 $22,680 $16,520 $23,800 $84,000

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The variable component of this budget for advertising and R&D is based on the quarterly sales
revenue figure as entered in the financial accounts (not as received in the form of cash). The
fixed elements of overhead are all traceable in the text of the case and the entire budget is paid
quarter by quarter as it is incurred.

Now that all the detailed schedules are compiled the financial controller would pull the various
components together in the form of a cash budget and budgeted profit and loss account and
balance for inventory, both raw material and finished goods.

1.4.7 Closing Inventory Budget for Year Ending March 31, 1998 (Schedule 7)

Q1 Q2 Q3 Q4 total
Direct material
Unit times $1 per
Unit--------------------$2580 $1960 $3000 $3000 $3000
Finished goods
Units------------------- 560 340 600 600 600
times variable cost--$55
cost--$55 $55 $55 $55 $55
$30,800 $18,700 $33,000 $33,000 $33,000

Readers will remember tat businesses carry inventory in their balance sheets at the lower of
cost or market value. The costs inserted in schedule 7 imply that the market values for both
metal and finished trolleys are greater than the cost. Should the position reverse the company
would be required to write off the difference immediately to the lose on redaction of cost to
market account. Notice also that the finished goods inventory valuation is , $55 each, that is the
variable cost of manufacture.

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1.4.8 Cash Budget for Year Ending March 31,1998 (Schedule 8)

Q1 Q2 Q3 Q4 Total
Opening balance------------$17,500 $(9668) $14,132 $28,156 $17,500
Cash from sales 130,000 189,700 142,100 182,700 644,500
Cash inflows $147,500 $180,032 $156,232 $210,856 $662,000
Direct material-----------$19,168 $26,220 $22,456 $26,256 $94,100
Direct labor -------------- 77,400 77,400 58,800 90,000 303,600
Manufacturing over.------39,600 39,600 30,300 45,900 155,400
Selling and admin.--------21,000
admin.--------21,000 22,680 16,520 23,800 84,000
$157,168 $165,900 $128,076 $185,956 $637,100
Closing balance (9,668) $14,132 $28,156 $24,900 $24,900

The cash budget comprises those elements from the previous schedules, which have an impact
on the inflows and outflows of cash over the next 12 months. The closing cash balance of
$17,500 in the balance sheet as at march 31,1997 forms the opening figure in the above
schedule. To this sum is added the cash received from sales in Q1 (see schedule 1,b). Outlays of
cash comprise direct materials (schedule 3.c), direct labor (schedule 4), manufacturing
overhead (schedule 5) and selling and general overhead (schedule 6). The closing cash balance
in Quarter1. a deficit of $9668, forms the opening balance in Quarter 2, and so on. The closing
balance in Q4. $24,900, forms the cash balance in the budgeted balance sheet as at march
31,1998.

The managerial significance of schedule 8 should not be ignored. A part from the deficit
balance in Quarter 1 caused by a low debtors figure to collect from the end of 1991 (see
schedule 1,b) which would provoke the financial director to arrange bridging facilities with the
company’s bankers, the build-up of cash need to be addressed. cash is not an asset that works
well for a business. True it earns interest, and it provides a cushion against which the company
can fall in times of hardship, but it is not productive in the real meaning of the word. Could the
company contemplate a better strategic use of the amount? Investment in more R&D? this kind
of analysis would only be undertaken when it became obvious that a cash mountain was
building up.

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1.4.9 Budgeted Income Statement for Year Ending March 31, 1998

Q1 Q2 Q3 Q4 TOTAL
Sales units 2500 2800 1700 3000 10000
$ $ $ $ $
sales revenue----------- 175,000 196,000 119,000 210,000 700,000
variable cost of sales
manufacturing---------(137,500) (154,000) (93,500) (165,000) (550,000)
administrative---------(14,000)
administrative---------(14,000) (15,680) (9520) (16,800) (56,000)
contribution margin---23,500 26,320 15,980 28,200 94,000
fixed costs of
manufacturing (2400) (2400) (2400) (2400) (9600)
selling and admin ------(7000) (7000) (7000) (7000) (28,000)
profit before tax--------14,000
tax--------14,000 16,920 6580 18,800 56,400

1.4.10 Budgeted Balance Sheet For Year Ending March 31, 1998 (Schedule 10)

Q1 Q2 Q3 Q4 TOTAL
Plant and equipment—75,000 75,000 75,000 75,000 75,000
Accumulated dep. (26,500) (28,000) (29,500) (31,000) (31,000)
Inventory:
Row arterials ---2580 1960 3000 3000 3000
Finished goods-30,800 18,700 33,000 33,000 33,000
Debtors------------------52,500 58,800 35,700 63,000 63,000
Cash----------------------(9668)
Cash----------------------(9668) 14,132 28,156 24,900 24,900
Total assets 124712 140592 145356 167900 167900
Ordinary shares-----30,000 30,000 30,000 30,000 30,000
Retained earnings---83,600 100,520 107100 125900 125900
Creditors------------ 11112 10072 8256 12000 12000
Total equity and
Liability---------------124712
Liability---------------124712 140592 145356 167900 167900

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The sales revenue line in the profit and loss account is taken from schedule 1a,. variable cost of
sales is the product of the quarterly sleds units and $55 per unit . variable selling and
administrative cost are derived from schedule 6 (the addition of variable advertising cost and
variable R&D costs). Contribution margin is the result of subtracting all variable costs from
sales revenue. Fixed costs come from two schedules: manufacturing from schedule 5 ($2400
per quarter includes $1500 depreciation) and selling and administration from schedule 6. for the
purposes of illustration we have ignored the impact of taxation. In reality tax would be
calculated for 1997/1998 on the final budgeted profit of $56,400 but not paid until the next
year.
The items in the balance sheet need little explanation
1. Accumulated depreciations opening balance of $25,000 is added to at the rate of $1500
per quarter.
2. Debtors are drown from schedule 1,b; the sums of money collected in the next quarter
are the debtors for the current quarter. Therefore the figure of $52500 collected in cash
in Q2 serves as the debtors figure for Q1. the paragraphs below schedule 1 explain
where the closing debtors figure in Q4 comes from
3. Retained earnings are old profits not distributed. The opening figure for 1997/98 is
$69,500; to this is added the profit figure from the income statement quarter by quarter.
4. Creditors, like debtors, is the figure paid out in the subsequent quarter; hence from
schedule 3,c, we see that $11112 paid in Q2 refers to purchases made in Q1. this then is
the creditors figure at the end of Q1.
The schedules, particularly schedules 8,9 and 10, would from the basis of a review by
the chief executive and a meeting with his functional managers. Adjustments may be
called for and the numbers reeked (a computer-based spreadsheet makes such
amendments an easy process). Eventually, agreement would be reached and the budget
distributed to the various departmental heads and other officials. Quarter by quarter
actual performance would be measured against budget and reasons for variances sought.

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1.5 DISCRETIONARY EXPENDITURE AND ZERO BASE BUDGETING

In an earlier section of this unit we mentioned the distinction between engineered costs and
discretionary costs. Engineered costs are those costs directly associated with the unit of output,
costs which have been engineered into the unit, costs without which the unit of out put would
cease to exist. Discretionary costs, on the other had, are those that dont need to incurred, at
least in the shout term. R&D, marketing, aspects of administration machine maintenance and
legal services are all examples of costs the level of which each year depends largely on
managerial discretion.

Why are discretionary costs so difficult to budget for and to manage? The principal difficulty
surrounds the measurement of output. What is the output of an R&D lab, for instance, or of a
legal department in a company? Sometimes the outputs of these activities are best measured
negatively. For instance, in a pharmaceutical company’s R&D lab a successful piece of research
may culminate in the conclusion that a certain mixture of compounds would be harmful or
ineffective; for the research scientist such an outcome is as valid as one which leads to the
development of a new drug. It would therefore be wrong to measure output in terms only of
successful experiments. Likewise in a lea department, the temptation to measure output in
terms of lawsuits defended or activated must be resisted when one considers that perhaps the
most successful legal work is done behind the scenes and is that which prevents and public
action being taken. Another problem associated with some discretionary areas is that the budget
holders are not sure of the corporate objectives and are therefore unsure of where their efforts
should be focused. Research and development tens to be subject to this breakdown in
communication; if care is not taken, pockets of scientific expertise can beaver away in areas of
investigative work which mirror individual interest rather than the strategic thrust of the
company. Careful top-level scrutiny of the budgets is essential to overcome this problem,
although it is not easy for non-scientists to penetrate the technical description of proposed
work. The third major issue concerning discretionary expenditure is that it is not necessarily
easy to control on annual basils. Some R&D programme run over several years and it is not
possible to terminate these without major disruption and upset to the morale of the staff
involved. A year is a short time in science.

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Set against these problems we must place the perception held by many budget holders of
engineered costs that much slack exists in discretionary budgets, that the R&D managers or
directors of legal services hide behind the mystique of their disciplines to grab more and more
scarce corporate resources which are squandered on needless work and generous staffing levels.
One technique designed to counter this fear is ASRE-FASE BUDGETING.

Seldom does a title of a topic in accounting display its contents so well as the term zero-base
budgeting (ZBB). For intend of adopting the normal incremental approach to annual budgeting
(let’s aim for a 3 percent reduction in costs across the board), management invites certain
activates to bid for their resources as if they were starting from scratch (or from a zero base).
This tool can only be adopted in area of discretionary expenditure where management must
decide the level of expenditure that is appropriate for the business at the current time ; with
engineered costs, however, the sole criterions of level of spend is the production output
required.

ZBB involves the analysis of an activity such as R&D or legal services or machine
maintenance it packages of work which can be separated from each other, starting with the
most fundamental activity and building up to the activity

Which were the resources to be made available, ranked in order of top management. Top
management must take a view on whether another fully qualified recruit to legal services, to
handle the growing problem of intellectual property rights, is more desirable for the company
in its current position than another maintenance engineer the addition of whom to the staff of
the maintenance department would provide 24-hour cover and thereby prevent costly
breakdown of machines on the night shift. These decisions are extremely difficult but the secret
of ZBB is that the decisions are made by top management and not by budget holders whose
vested interests are inextricably bound up with their budget proposal. ZBB also requires
corporate functions to identify minimum levels of expenditure below, which their activities
cannot really operate. New requests for increase spending must be given a priority against
existing commitments.

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Check Your Progress –2

1. What is discretionary expenditure

………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
2. What is zero base budgeting
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………

1.6 SUMMARY

Regardless of commercial environment, budgeting co-ordinates diverse activities, helps

planning, promoted employee motivation and provides a benchmark against which to measure
actual performances. Good budgeting procedures shorten the lead time between starting the
budgeting exercise and the beginning of the budget period, needs the full backing of top
management, and prompt a feeling of ownership of the budget numbers among the managers
who helped to construct them.

Engineered budgets are easier to construct than discretionary budgets because the outputs from
discretional activates such as marketing and R&D are not easily measurable. Zero-base
budgeting is a device which can be used in discretionary areas of a business which helps to
remove some of the managerial subjectively and self-interest, thereby leasing funds for use in
more deserving parts of the business.

1.7 ANSWERS TO CHECK YOUR PROGRESS

CYP –1
1. Refer section 1.2
2. Refer section 1.3
CYP –2
1. Refer section 1.5
2. Refer section 1.5

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1.8 MODEL EXAMINATION QUESTIONS

1. The task of budget preparation produces clear benefits to companies. These include:
i. Increasing the motivation of individual heads of departments;
ii. The provision of a benchmark against which to measure actual performance
iii. An explanation of the detail in last years profit and loss account
iv. Improved co-ordination of activities between departments.
Which of the following is correct
a. (i) and (ii)
b. (i) ,(ii) and (iii) only
c. (i), (ii) and (iv) only
d. (ii), (iii) and (iv) only.
2. The budgeting process is vital to a company because it is a financial statement which focuses
on a comparison of historical costs. Tue or false?
3. Which of the following describes a budget?
a. Strategic plan
b. A calash flow forecast.
c. A review of management performance
d. A numerical expression of a plan of action
4. If middle management has confidence in the achievability of the budget, then it is wholly
irrelevant if senior management chooses to ignore the entire budget process. True or false/
5. If a company operates in a market with unlimited demand for its product which of the
following is the first budget to be prepared?
a. Production budget
b. Cash budget
c. Sales budget
d. Purchases budget
In planning the next quarters production, the plant manager for product R2 has been asked
to take into account the following data.

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 product R2 row material
units (kg)
Opening inventory------------------------1000 30,000
Panned closing inventory----------------2000 10000
Budgeted sales ----------------------------10000 _
Each unit of product R2 requires 5 kg of raw material
6. How many units of product R2 have to be manufactured in the next quarter?
a. 10000
b. 11000
c. 12000
d. 13000
7. How many kg of raw material have to be purchased to meet the manufacturing target for
product R2
a. 30000 kg
b. 35000 kg
c. 50000 kg
d. 65000 kg

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