LaiACCT3500/Fall 20 (lecture 7)

ADA University, School of Business

ACCT3500, Managerial Accounting, Fall 2020
Lecture 7 – Budgeting

Introduction.
 Budgets are prepared using standards for example:
It should take 10 minutes to make one unit of output (standard time);
using labour costing £6 per hour (standard labour cost) and
1 Kg of material costing £2.50 per Kg (standard volume and cost of material) .
Overheads are absorbed at the rate of £6 per hour (standard overhead
absorption rate).
• Budgets are plans – usually for one year - but they are not an end in
themselves.
• A budget is more than a forecast as it implies a commitment.
• Budgets are also a control device as they are used to compare what actually
happened with what is expected to happen (the budget).
• If there are differences (variances) they must be investigated – look for
causes and corrective action.
• Difference between standard and budgeted costs – a budget relates to an
entire activity or operation while a standard presents the cost on a per unit
basis.

Standard Costs.
• They are used mainly in mass-production industries as they are not practical
for customized products.
Advantages of standard costing:
• In the setting or preparation of standard costs, it is necessary to conduct a
thorough review of the operations of the company.
• Monitoring the standard cost / variances directs management attention to
costs / problems, especially if actual costs are substantively more than
budgeted.
• Realistic standards can motivate employees to achieve them
• Standard costs can be used to value stocks and set selling prices.
• Standard Costing Variance Analyses are commonly used to evaluate
managerial performance.

Types of Standard Costs.

• Ideal – no allowance is made for waste and this type of standard cost can be
de-motivating and “disruptive” for planning.
• Normal / currently attainable standard:
– An allowance is made for waste, thus standards set are achievable and
therefore motivating;
– under efficient conditions, standards are difficult but not impossible to
achieve.

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Advantages of Budgeting.
• Forces managers to plan.
• The budget is commonly used in managerial performance evaluation.
• Budget encourages inter-departmental coordination (for example the sales
department will have to consult with the production department which in turn
will have to coordinate with the purchasing / finance departments.
• Budget encourages inter-departmental communication as in the example
given above.
• Can be motivating for employees through meeting the targets set and
especially if the employees also participated in setting the budget / cost
targets (“sense of ownership” of the cost targets).
• Budgets are commonly used as a control device – through the variances
measured and resulting feedback.
• Budget serves as a mechanism for the efficient allocation of scarce resources
in the company – in the sense that more resources should be provided for
more efficient departments within the entity.
• The monitoring of cost variances alert management to problem areas -
Management by Exception.

Disadvantages / problems of Budgeting.

• Not all employees (type B individuals) are motivated by participation in the
budget setting process. Type B individuals who exhibit “apathy” prefer the
budget / cost targets to be set for them. Many employees also view the budget
with its cost and sales targets as a pressure device.
• Budget can lead to departmental conflict as the various departments compete
for scarce resources, resulting in non-cooperation, and “passing the buck”
when problems arise.
• Can result in suboptimal decisions which lead to short-term departmental
gains at the expense of long-term organizational gains, for example a manager
will not purchase an equipment which will save the company enormous cost
savings in the future if the purchase means the department is going to exceed
its current budget.
• Slack creation – departments will ask for more resources than is needed.
• Unnecessary spending at the end of the financial year (“Christmas shopping”)
– especially by departments which are afraid they will be given less resources
in future budgets if they do not spend the funds allocated to them in the
present budgets.
• Standards set may be bad.
• Budgets are estimates which relate to the future, thus involve a certain degree
of uncertainty; however, measures taken to reduce this uncertainty include
probabilities, rolling budgets and sensitivity analysis.

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 LaiACCT3500/Fall 20 (lecture 7)

Master Budget.
• The Master Budget consists of the Budgeted Profit and Loss account, Balance
Sheet, Cash Flow and Capital Expenditure budget.
• Steps in preparing the master budget:
– Identify Limiting Factor
• Limiting factor – the constraining factor which limits the
operation of an entity; examples are sales units, finance, supply
of raw materials, space or skilled labour.
• If market demand is the limiting factor, do a sales forecast
(consider past sales; economic, industry, seasonal and company
factors).
– Undertake Sales Forecast.
– Prepare Functional Budgets:
• Sales budget ($ and units)
• Production budget (units only)
• Raw materials purchase budget ($ and units)
• Direct labour budget ($ and units)
• Manufacturing overhead budget ($)
• Closing stock budget ($ and units)
• Cost of goods sold budget ($ and units)
• Non-production cost budget e.g. administration, financial,
research and development
– Prepare the master budgets after functional budgets.
- Review and discussion – final approval by Budget Committee.
- Subsequent revisions – only if new major developments render the
budget meaningless.

Cash Budget.
• Shows planned receipts and payments of cash for coming year / period.
• Receipts of cash - from cash sales, payments by debtors, sale of fixed assets,
issue of new shares, etc.
• Cash payments - for purchase of stock, payment of wages or other expenses,
purchase of capital equipment, interest on loans, etc.
• only considers cash flows (not accounting profits).

Preparing the Cash Budget:

• When preparing the cash budget – (i) ignore non-cash items; and (ii) allow
time lags on accruals / credit transactions.
• Example of (i) - cash budget will not include following items (compare
with P & L account):
- depreciation
- bad debt provision
- profit/(loss) on sale of a fixed asset

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 • Example of (ii) - Goods purchased (or sold) in January are paid for (or
payment received) in March. The cash flow occurs in March so it's
recorded in the March cash budget.

Functions of Cash Budget.

• Ensure cash is available for day-to-day expenses and other revenue
expenditure.
• Shows when, where and how much cash will be needed; & whether this will be
permanent or temporary.
• Preserve liquidity throughout the year.
• Reveal surplus cash for investment or expansion of facilities.
• Guide management on whether to finance capital expenditure internally or
externally.
• Reveal effects of changes in corporate policy e.g. credit control policy (change
of credit period for customers from 60 to 30 days).

Common Format of Cash Budget.

(a) Receipts
(b) Less payments
(c) = Net cash flow in month
(d) +/- Opening cash balance or balance b/f
(e) = Closing cash balance or balance c/f

Example of Cash Budget Preparation.

Using the following budgeted information relating to a university book shop, draw
up a cash budget for the period January to March 2017
- Annual cost of rent for premises £92,000
- Annual Depreciation charge for Fixtures
and Fittings £10,000
- Staff Salaries (per month) £16,400
- Average variable cost per book sold £30
- Average selling price per book sold £54

 
Forecasted monthly sales (in numbers of books) for the first three months of the
year are as follows:
January February March
545 583 620

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Additional Information:
• Rent is spread across the calendar year and is payable monthly in equal
instalments.
• Staff salary costs are spread evenly across the year and paid on the last day
of the month.
• Variable costs are allocated according to expected sales volume and are paid
in the month following sale.
• Sales are all for cash.
• The opening balance of cash on 1st January is expected to be £22,800.

January February March April

Sales (£) 29,430 31,482 33,480
Expenses (£)
Rent (7,667) (7,667) (7,667)
Staff salary (16,400) (16,400) (16,400)
Variable - (16,350) (17,490) (18,600)
costs
Net Cash 5,363 (8,935) (8,077)
Flow
Balance b/f 22,800 28,163 19,228
Balance c/f 28,163 19,228 11,151

Budgeting Alternatives.
• Types of approach:
– Top down (imposed budgets);
– Bottom up (participative budgeting).
• Method:
– Incremental budgeting.
– Zero based budgeting (ZBB).

Incremental Budgeting.
• An approach which takes current budget as base for preparation of next–
period budget. Base is then adjusted for expected changes in price, volumes
and product mix to arrive at the new budget.
• This approach has the major drawback that all past waste and inefficiencies
inherent in current way of doing things is perpetuated – assumes current
budget incorporates justified activities, good working practices and
acceptable cost efficiency.

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Zero-Based Budgeting (ZBB).
• Traditional budgeting is incremental in nature; that is, what happened last
year, add on a percentage for inflation, volume, etc.
• The disadvantage of traditional budgeting is it carries forward past
inefficiencies.
• ZBB starts off from zero every year – all activities are re-evaluated as if new;
managers have to justify what they do and rank their activities based on a
cost-benefit approach.
• Disadvantage of ZBB is it is repetitive and time consuming.
• For each activity, the following questions will be asked:
- What are the objectives of an existing activity?
- Is it essential in the long run?
- Do benefits outweigh the costs?
- Are there alternative ways of providing the activity more cost
effectively?
- Is the activity at the correct level?

Advantages of ZBB:
• Promotes search for better alternatives.
• Costs must be matched to benefits.
Disadvantages of ZBB:
• Repetitive and time consuming.

Conclusions.
• Companies now plan for shorter time horizons (1 – 3 years) compared to 5 –
10 years before.
• Reason is the business environment – technology, competition, uncertainty -
changes faster today than before.

Readings:
• Drury C, Management and Cost Accounting, 9th edition, 2015, Cengage
Learning, chapter 15.
• Proctor R, Managerial Accounting: Decision Making and Performance
Management, 4th edition, 2012, Pearson, chapters 14 and 16.

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 ADA University, School of Business
ACCT3500, Managerial Accounting, Fall 2020
Seminar 7 – Budgeting

 Issue 1:
David is planning to open a delivery-only pizza shop in South London.
Forecast monthly sales (in numbers of pizzas) are as follows:

June July August September

940 910 995 1,200

The following information is relevant:

 Average selling price of each pizza £9.00

 Average material cost of each pizza £2.50
 Delivery cost of each pizza £1:00
 Deposit for the shop £14,000
 Initial cost of shop fittings £15,200
 Annual rent £21,600
 Annual staff salary £36,600
 Utility bills £1,120

Additional Information:
i. Sales are all for cash.
ii. Suppliers of material will be paid in the month following the material purchase.
David only buys enough material in each month to cover sales for that month.
iii. Utility bills are received every two months and paid in the month following the
receipt of the bill. The first bill is due in July.
iv. Rent is payable monthly in equal instalments starting in June.
v. Staff salaries are payable monthly starting in June.
vi. David is planning to spend £2,500 in June, £1,800 in July & £2,000 in August, and
£3,000 in September on advertising.
vii. The opening balance of cash on 1st June is expected to be £34,000

Required:
(a) Prepare a cash budget for David covering the period from June to September.
Your cash budget should also include a total column.
(b) Explain briefly three of the main reasons for budgeting in general by organisations.

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 Issue 2:
Using the following information relating to Dauntless Book Shop, draw up a cash budget for the
period January to March 2018

Annual cost of rent for the premises £46,000

Annual Depreciation charge for Fixtures and Fittings £5,000
Staff Salaries and National Insurance (per month) £8,200
Average variable cost per book sold £15
Average selling price per book sold £27

Forecasted monthly sales (in numbers of books) for the first three months of the year
January February March
1,290 1,165 1,240

Additional Information:
(i) Rent is spread across the calendar year and is payable monthly in equal instalments
(ii) Salary costs are spread evenly across the year and paid on the last day of the month.
(iii) Variable costs are normally allocated according to expected sales volume and are paid in the
month following sale.
(iv) Sales are for cash
(v) The opening balance of cash on 1st January is £11,400.

 Issue 3:
Analyze the differences between incremental budgeting and zero based budgeting.

 Issue 4:
(a) John Smith is planning to open a book shop in Central London selling university text
books. He has asked you to prepare a cash budget for a three-month period from
September to November using the following information:

Deposit for the shop £30,000

Annual rent for the shop £40,800
Annual depreciation charge for fixtures and fittings £16,400
Annual staff salaries and National Insurance £55,800
Utility bills (gas, electricity, telephone, etc) £1,360
Advertising £860
Average purchase price of each book sold £30
Average selling price per book sold £54

Forecasted monthly sales (in numbers of books) for the four-month period below are as
follows:

September October November December

645 980 620 325
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 Additional Information:
i. Shop deposit paid in September.
ii. Rent is spread across the calendar year and is payable monthly in equal
installments.
iii. Staff salary costs are spread evenly across the year and paid on the last day
of the month.
iv. Utility bills are received every two months and paid in the month the bills are
received, the first one being due in November for the previous two months.
v. John plans to carry out a newspaper advertising campaign in September
costing £860 which will be payable in October.
vi. In any month, John plans to have stock of books enough for that month and
the following month’s sales. The books are purchased on credit and paid for
in the month following the month of purchase.
vii. Sales are all for cash.
viii. The opening balance of cash on 1st September is expected to be £12,800.

Note: No mention of the costs of fixtures and fittings, assume they are bought in
September and only paid for in December (that is, given 3 months’ credit).

(b) Explain six of the main reasons for budgeting in organizations.

 Issue 5:
Jones Ltd plans to start a business on 1st June making & selling personal computers.

Budget details
The budgeted sales for the first three months are expected to be £700,000. It is
expected that 20% of the first quarter's sales will be achieved in June, 35% in July and
the remainder in August.

Customers must pay a deposit of 20% of the value of the order when they sign the
contract. 30% is paid one month later and the remaining 50% of the sales value is paid
two months later. No bad debts are anticipated in the first three months of trading.

There are eight people employed by the company, each earning an annual gross salary
of £32,000, payable on the last day of each month.

Computer components will be purchased each month equal to 60% of that month’s
sales. Trade creditors are paid in full in the month following the purchase.

The company has decided to rent premises that will require an initial deposit of £20,000
and an ongoing monthly rent of £3,000 payable on the first day of each month.

A marketing and advertising campaign will be launched in June at a cost of £9,000 with
further monthly campaign costing £4,000 starting in July.
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Administration overhead is budgeted to be £1,700 per month, 40% to be paid in the
month of usage and the balance one month later.

The company will have £30,000 of cash in the bank on 1 st June.

NOTE: Ignore tax and interest charges

Required:
a) Prepare the cash budget by month and in total for the three months period June to
August for Jones Ltd.
b) Suggest ways in which a cash shortfall in any month during the budget period in this
question can be addressed by the company’s management.

 Issue 6:
Homer is planning to start a business providing marketing consultancy service to
businesses in London. He will lease an office in central London and employ a secretary to
help him with the administration side of the business.
Forecast monthly fee incomes are estimated as follows:

June July August September

£3,400 £6,100 £7,500 £6,800

The following information is relevant:

 Initial lease premium for the office £25,000
 Annual rent of the office £19,200
 Annual salary of the secretary £18,000
 Utility bills (electricity, gas, telephone, etc) £720
 Annual business rates £16,800

Additional Information:
i. Homer’s clients pay 30% of their invoice amount as deposit at the time of signing
their contract and the remaining 70% is paid in the month following the date of the
contract. Homer provides the service and issues the invoice in the month in which
the contract is signed.
ii. Utility bills are received every two months and paid in the month following the receipt
of the bill. The first bill will be received in July.
iii. Rent is spread across the calendar year and is payable monthly in equal instalments
starting in June.
iv. Staff salary cost is spread across the calendar year and is payable monthly starting
in June.
v. Business rates are paid in four quarterly equal instalments. The first instalment is
due in August.
vi. Homer is planning to spend £2,500 in July, £1,800 in August on advertising.
vii. The opening balance of cash on 1st June is expected to be £30,000.
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Required:
a) Prepare a cash budget for Homer covering the period from June to September. Your
cash budget must also include a total column.
b) Briefly compare the incremental budgeting and zero based budgeting.

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