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Course: Cost and Management Accounting

Course Code: ACCT 3501
Unit IV: Budgets, Planning and Control

A budget is the plan, stated in financial terms, of how the organization expects to carry out its
activities and meet the financial goals established in the planning process. CIMA’s Official
Terminology defines a budget as ‘… a plan expressed in money. It is prepared and approved
prior to the budget period and may show income, expenditure and the capital to be employed.’

Budgeting refers to the process of preparing the budget. Budgetary control refers to the use
of budgets to increase the likelihood that the objectives set out in the budget are attained and to
ensure that the organization functions in a way that is consistent with its policies. If the firm has
no effective system of budgetary control, then budgeting is a waste of time and resources.

Insert Lucey graphic on Budgeting and budgetary control

The Budget Committee

The Advantages/Benefits of Budgeting

Budgeting serves to:

1. force managers to plan in a structured way

2. coordinate the activities of the organization into a single master plan.
3. communicate the organization’s policies and targets to every manager responsible for
implementing these policies and achieving these targets.
4. motivate managers to achieve the organization’s objectives (to enhance goal
congruence)
5. provide a system of control by having a plan which can be used as a basis of assessing
actual results. In this regard, budgets make it possible for businesses to highlight on
areas not operating as expected, and focus its resources in analyzing these items and
taking appropriate action. This practice is known as management by exception.
6. identify potential bottlenecks before they occur; this allows managers to take appropriate
action to avoid these bottlenecks or, where that is not possible, to minimize their effects.
7. allocate the organization’s resources to those areas where they may be used most
effectively.

Disadvantages/ of Budgeting

1. The budget process is time-consuming

2. Budgets can be seen as pressure devices imposed by management, thus resulting in:

i) bad labour relations

ii) inaccurate record-keeping.
iii) demotivated managers and employees
3. Departmental conflict may arises due to:
i) disputes over resource allocation
ii) departments blaming each other if targets are not attained.
4. It may be difficult to reconcile personal/individual and corporate goals
5. Budgets may act as a barrier to change.
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6. Managers may overestimate costs (pad the budget) so that they will not be blamed in
the future should they overspend.

The Human Side of Budgeting

https://www.assetworks.com/resource-items/procurement-top-down-vs-bottom-up-infographic/

Participative budgeting/Self-imposed budgets

Top management has the ultimate responsibility for the budgets of the organization they
manage. Management at all levels, however, should understand and support the budget and all
aspects of the management control system. If the budget is to achieve the objectives of
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motivation and enahancing goal congruence, lower- and middle-management employees

should be an integral part of the process. This is known as participative budgeting (or bottom-
up budgeting). While use of lower and middle managers in budgeting is time-consuming,
participative budgeting has many benefits:
i. it enhances employee motivation and acceptance of goals and
ii. it provides information that enables employees to associate rewards and penalties with
performance
iii. it results in more accurate information being used to develop the budget and, ultimately,
the development of a more realistic budget.

Top-Down Budgeting/Imposed budgets

Budgets are developed by top management with little or no input from middle/line managers.
While budgets are important control tool, they should not be used to penalize managers. If line
managers see the budget in this light, they are likely to pad their budgets as the ‘slack’ makes
targets easier to achieve. Additionally, if the budget is imposed by senior management, mid
and lower level managers are less likely to ‘buy in’ to the budget. This makes it less likely that
they will work to achieve the targets set out in the budget.

Terms Associated with Budgets and Budgeting

a) Planning
b) Budgeting
c) Management by exception
d) Zero-Based Budgeting
e) Activity-Based Budgeting
f) Responsibility Accounting
g) Rolling Budget
h) Master Budget
i) Flexible Budget
Principal Budget Factor

You should ensure that you can define and explain the significance of each term.
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Preparation of Budgets

The Master Budget

The business will prepare a budget for various aspects of the organization. These are
combined to form the master budget. The master budget is made up of operating budgets
(which consist of the budgeted income statement and its supporting budgets) and financial
budgets (the capital budget, cash budget, budgeted statement of financial position, and
budgeted statement of cash flows)

Source: Costing by T. Lucey

The major steps in preparing the master budget are:

1. Prepare a sales forecast.

2. Determine production volume.
3. Estimate manufacturing costs and operating expenses.
4. Determine cash flow and other financial effects.
5. Formulate projected financial statements.

i) The Sales Budget This is usually the starting point in preparing the master budget, as
sales volume is a major determinant of many of the business’ costs. Sales are therefore
usually the principal budget factor. The sales budget is based on estimated sales
volume and unit prices for the budget period. If the business sells on credit terms, the
sales budget is usually supported by a schedule of cash collections.
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ii) The Ending inventory Budget This sets the expected ending inventories based on the
company’s policy

iii) The Production Budget This budget shows the production required to meet the
requirements for sales and ending inventory.

Production = Sales + Ending Inventory – Beginning Inventory

NB: The production budget will only be required for manufacturing firms.
Retailers/merchandisers trade in finished goods, and so will not need a production
budget

iv) The Direct Materials Purchases Budget This shows show how much material will be
required for production and how much material must be purchased.

Purchases of materials = Usage + Ending Inventory– Beginning Inventory

of materials of materials of materials

If the business purchases materials on credit terms, the purchases budget is usually
supported by a schedule of cash disbursements.

v) The Direct Labour Budget shows the direct labour costs for the budget period.

Direct labour cost = Direct labour hours per unit x units produced x rate per hour

vi) The Manufacturing Overhead Budget shows all manufacturing costs other than direct
materials and direct labor.

vii) The Selling and Administrative Expense Budget lists the operating expenses involved in
selling the products and in managing the business

viii)The Cash Budget shows the expected cash inflow and outflow for a designated time
period.

ix) The Budgeted Income Statement summarizes the various component projections of
revenue and expenses for the budgeting period.

x) The Budgeted Statement of Financial Position shows the assets, liabilities and capital at
the end of the budget period

Notes on the Cash Budget

The Cash Budget is a vital tool of working capital management. It shows the firm’s expected
cash inflows and outflows for a designated time period.
The cash budget is especially important as it allows the business to anticipate potential cash
shortages and to take remedial action such as:
 Rescheduling capital expenditures
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 Seeking financing for capital projects

 Arranging for overdraft facilities to support day to day expenses
 Tightening the collection period for credit sales (this may result in higher
discounts allowed expense)
 Taking a longer period to pay creditors (This may result in a loss of discounts or, if
the business exceeds the agreed maximum payment period, in a loss of credit
privileges)

If the cash budget indicates that the business may have significant cash surpluses, managers
may:
 Invest short term (temporary) surpluses in highly liquid assets such as marketable
securities
 Finance capital projects
 Reduce debt

Cash Budget Format

Q1 Q2 Q3 Q4
$ $ $ $
Receipts
Collections from sales
Tax refund
Sale of fixed assets
Total receipts
Payments
Payments for purchases
Wages and salaries
Rent
Other expenses
Purchase of fixed assets
Taxes
Total payments
Receipts - Payments
Add: beginning cash balance
Ending cash balance before financing (1)
Less : Minimum desired cash balance
Projected cash surplus (deficiency)
Financing
Borrowing
Interest Payment
Principal repayments
Net effects of financing (2)
Ending cash balance(1) + (2)
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LECTURE PROBLEMS

1. Red Gabby, owner of RG Wholesalers, is negotiating with the Caribbean Development

Bank for a $200 000, 12 per cent, 90-day loan, effective July 1 of the current year. If the
bank grants the loan, the proceeds will be $194 000, which Red Gabby intends to use on
July 1 as follows: Pay accounts payable, $150 000; purchase equipment $16 000; add
to cash balance, $28 000.

The current working capital position of RG Wholesalers, according to financial

statements as of June 30, is as follows:

$
Cash in bank 20 000
Accounts receivable (net of allowance for doubtful amounts) 160 000
Merchandise inventory 90 000
Total current assets 270 000
Accounts payable (including accrued operating expenses) 150 000
Working capital 120 000

The bank loan officer asks Red Gabby to prepare a forecast of his cash receipts and
cash payments for the next three months to demonstrate that the loan can be repaid at
the end of September.

Red Gabby has made the following estimates which are to be used in preparing a three-
month cash budget: sales (all on credit) for July, $300 000; August $360 000;
September, $270 000; October $200 000. Past experience indicates that 80 per cent of
the receivables generated in any month will be collected in the month following the sale,
19 per cent in the second month following sale and 1 per cent will prove uncollectible.
Red Gabby expects to collect $120 000 of the June receivables in July and the
remaining $40 000 in August.

Cost of goods sold has consistently averaged about 65% of sales. Operating expenses
are budgeted at $36 000 per month plus 8% of sales. With the exception of $4 400 per
month depreciation expense, all operating expenses are paid in the month following their
incurrence.

Merchandise inventory at the end of each month should be sufficient to cover the
following month’s sales.

Prepare the following schedules for each of the three months - July, August and
September:

a. Cash collections on accounts receivable

b. Purchases budget
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c. Estimated cash payments for accounts payable and operating expenses.

d. Cash budget

e. On the basis of the cash budget, discuss whether it is likely that RG Wholesalers
will be likely to be able to repay the $200 000 loan to Caribbean Dominion bank
at the end of September

(CXC Cape)

2. Acred Ltd manufactures a single product. It is preparing monthly budgets for the six
months from July to December 2014. The following standard revenue and cost data is
available:

Selling price $12·00 per unit

Materials 2 kg per unit at $2·40 per kg
Labour $1·80 per unit
Direct expenses $1·20 per unit

Sales in June 2014 and July 2014 are forecast to be 10,000 units in each month. As a
direct result of marketing expenditure of $95,000 in August 2014, sales are expected to
be 11,000 units in August 2014 and to increase by 1,000 units in each month from
September to December. Sales after December 2014 are expected to remain at the
December 2004 level.

25% of sales are paid for when they occur and 75% of sales are paid for in the month
following sale.

Stocks of finished goods at the end of each month are required to be 20% of the
expected sales for the following month. Stocks of materials at the end of each month are
required to be 50% of the materials required for the following month’s production.
Materials are paid for in the month following purchase.

Labour and direct expenses are paid for in the month in which they occur. Overheads for
production, administration and distribution will be $34,000 per month, including
depreciation of $12,000 per month. These overheads are payable in the month in which
they occur.

Acred Ltd has a $750,000 bank loan at 8% per annum on which it pays interest twice per
year, in March and September.

The cash balance at the end of June 2014 is expected to be $50,000.

Required:
For the six month period from July to December 2014, prepare the:

i. Sales budget
ii. Schedule of cash collections
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iii. Production budget

iv. Materials purchases budget
v. Direct labour and expenses budget
vi. Cash budget
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