MA. M4. Notes

MA - Budgeting
Contents
Introduction to Budgeting ........................................................................................................... 4
DEFINITIONS: ........................................................................................................................... 4
STAGES IN THE BUDGET SETTING PROCESS: ........................................................................... 5
BUDGET COMMITTEE: ............................................................................................................. 6
Sales and Production Budgets ..................................................................................................... 7
DEFINITIONS: ........................................................................................................................... 7
PRODUCTION BUDGET: ........................................................................................................... 7
Materials and Labour Budgets .................................................................................................... 9
MATERIAL BUDGETS: ............................................................................................................... 9
LABOUR BUDGETS: .................................................................................................................. 9
Overheads Budgets ................................................................................................................... 11
VARIABLE PRODUCTION OVERHEADS BUDGET:.................................................................... 11
FIXED PRODUCTION OVERHEADS BUDGET: .......................................................................... 11
Budgeted Statement of Profit or Loss ....................................................................................... 13
Example Budget Preparation .................................................................................................... 14
PROFORMA OF BUDGETED STATEMENT OF PROFIT OR LOSS: ............................................. 14
Fixed Budgets ............................................................................................................................ 17
DEFINITION: ........................................................................................................................... 17
FIXED BUDGET PROFORMA: .................................................................................................. 17
Flexible Budgets ........................................................................................................................ 18
DEFINITION: ........................................................................................................................... 18
FLEXIBLE BUDGET PROFORMA: ............................................................................................. 18
ILLUSTRATION 1: .................................................................................................................... 19
Cash Budgets ............................................................................................................................. 21
Cash Budgets and “What If” Analysis ........................................................................................ 25
1
Budgeted Statement of Financial Position ................................................................................ 28
DEFINITION: ........................................................................................................................... 28
ILLUSTRATION: ....................................................................................................................... 29
Budgetary Control ..................................................................................................................... 30
DEFINITIONS: ......................................................................................................................... 30
VARIANCES:............................................................................................................................ 30
TYPES OF VARIANCES: ........................................................................................................... 30
CONTROL STAGE OF PLANNING AND CONTROL CYCLE: ....................................................... 30
BUDGETARY CONTROL REPORT TEMPLATE: ......................................................................... 31
BUDGETARY CONTROL REPORT - ILLUSTRATION: ................................................................. 32
Compounding ............................................................................................................................ 33
Discounting................................................................................................................................ 35
DEFINITIONS: ......................................................................................................................... 35
FORMULAE:............................................................................................................................ 35
Annuities ................................................................................................................................... 36
DEFINITION AND FORMULA: ................................................................................................. 36
SCENARIOS: ............................................................................................................................ 36
Perpetuities ............................................................................................................................... 38
SCENARIOS: ............................................................................................................................ 38
Capital Investment Appraisal .................................................................................................... 40
DEFINITION: ........................................................................................................................... 40
CASH FLOWS TO CONSIDER: .................................................................................................. 40
CAPITAL INVESTMENT APPRAISAL STEPS: ............................................................................. 41
Net Present Value ..................................................................................................................... 42
STEPS TO CALCULATE NPV:.................................................................................................... 42
NPV PROFORMA: ................................................................................................................... 42
Internal Rate of Return.............................................................................................................. 44
2
ILLUSTRATING IRR:................................................................................................................. 44
CHOICE RULES: ....................................................................................................................... 45
Payback...................................................................................................................................... 46
DISCOUNTED PAYBACK CALCULATION IN STEPS:.................................................................. 46
UNDISCOUNTED PAYBACK CALCULATION IN STEPS: ............................................................ 47
Budgetary Control and Reporting ............................................................................................. 49
VARIANCE ANALYSIS .............................................................................................................. 53
RESPONSIBILITY ACCOUNTING .............................................................................................. 55
IDENTIFYING CONTROLLABLE AND UNCONTROLLABLE COSTS............................................. 55
CONTROL REPORTS ................................................................................................................ 56
Budgeting and Behaviour .......................................................................................................... 61
IMPORTANCE OF MOTIVATION ON PERFORMANCE: ........................................................... 61
THE IMPACT OF PARTICIPATION IN THE BUDGET SETTING PROCESS: .................................. 61
ANTHONY HOPWOOD’S MANAGEMENT STYLES: ................................................................. 64
UNINTENDED CONSEQUENCES OF BUDGETING: .................................................................. 65
CONTROLLABILITY AND MOTIVATION:.................................................................................. 65
IMPACT OF INCENTIVE SCHEMES ON BEHAVIOUR: .............................................................. 65
3
Introduction to Budgeting
DEFINITIONS:
Budgeting - future plan of expected revenues and expenditures for a budget period.
Budget period - specified period for which future plan is written.
Budget time specifications:
1) Prepared during the planning stage of planning and control cycle;
2) Prepared before budgeting period starts;
3) Variances (differences between actual results and budget) are calculated at the control
stage of the planning and control cycle.
Planning stage components:
Importance of budgeting:
− Estimation of revenues from products and services in the future period.
− Planning of spending the generated revenue.
4
Types of budget:
a) Sales budget;
b) Production budgets;
c) Materials budgets;
d) Labour budgets;
e) Overheads budgets;
f) CAPEX budgets;
g) Master budgets:
− Cash budget;
− Budgeted statement of profit or loss;
− Budgeted statement of financial position.
STAGES IN THE BUDGET SETTING PROCESS:
1) Identify any limiting factors or principal budgeting factor;
2) Prepare individual budgets;
3) Review individual budgets;
4) Revise individual budgets where required;
5) Agree on final individual budgets;
6) Prepare budgeted statement of profit or loss;
7) Prepare cash budget;
8) Prepare budgeted statement of financial position;
9) Prepare master budget;
10) Compare actual and budgeted results (variances).
5
BUDGET COMMITTEE:
The formation of a budget committee is important for budget preparation.
Budget committee responsibilities:
− Preparing the budget manual;
− Coordinating the budgeting process;
− Approval of individual budgets.
Members of the budget committee:
− Chairman;
− Budget officer;
− Budget managers;
− Member of the finance department.
Budget manual - reference manual which sets out recommended procedures to follow in the
budget-setting process. The budget manual includes guidance on individual budget preparation
and provides relevant forms.
6
Sales and Production Budgets
DEFINITIONS:
Limiting budget factor (or principal budget factor) – A factor which limits a company’s activity
levels, for example, sales as demand is limited. A budget based on a limiting factor must be
prepared first and influences all other budgets.
SALES BUDGET:
Sales budget = Budgeted sales in units x Budgeted selling price
PRODUCTION BUDGET:
Description Units
Material usage budget (or budgeted sales in units) x
Add: Closing inventory* x
Less: Opening inventory* (x)
Production budget in units X
*Information regarding the opening and closing inventory may be given in the question or you
may be required to calculate it.
Budgets, which can be prepared with the use of a production budget:
− Materials budget
− Labour budget
− Overhead budget
7
EXAMPLES:
Example 1:
Product X is the only product manufactured by Y Company. In Year 2, Y Company expects to sell
2,000 units of Product X at a selling price of $150 per unit. Calculate the sales budget.
Solution:
Sales budget = Budgeted sales in unit x Budgeted selling price
Sales budget = 2,000 x $150
Sales budget = $300,000
Example 2:
Product H is the only product manufactured by K Company. In Year 2, K Company expects to sell
2,000 units of Product H. There are 200 units of opening inventory and K Company wishes to
have 300 units of closing inventory at the end of the year. Calculate the budgeted production
units.
Solution:
Description Units
Budgeted sales 2,000
Add: Closing inventory 300
Less: Opening inventory (200)
Production budget in units 2,100
8
Materials and Labour Budgets
MATERIAL BUDGETS:
There are two types of materials budget:
− Materials usage budget
− Materials purchase budget
Materials usage Budgeted Quantity of material to make Standard

= x x
budget in $ production in units one unit of product* cost*
Materials purchases budget:
Description Units of material
Material usage budget x
Closing inventory x
Less opening inventory (x)
Material purchases budget X
Cost of material purchase in $ = Material purchases budget x Standard cost*
LABOUR BUDGETS:
Labour budget in Budgeted production Hours to make one Standard labour rate
= x x
$ in units unit of product* per hour*
Note: Amounts with an asterisk should be taken from the standard cost card.
9
EXAMPLE:
The standard cost card for Product X is as follows:
Cost $
Direct materials - 4 kg of Material B @ $10 per kg 40
Direct labour - 2 hours @ $6 per hour 12
Variable production overheads 2
Fixed production overheads 4
Total absorption cost 58
The business has budgeted to produce 1,800 units of Product X. The opening and closing stock
of Material B are expected to be 400 and 500 respectively.
Calculate the following:
− Materials usage budget in $
− Materials purchase budget in $
− Labour budget in $
Solution:
Materials usage budget in kg = $1,800 x 4 = 7,200 kg
Materials usage budget in $ = 7,200 x 10 = $72,000
Materials purchase budget in kg = 7,200 + 500 - 400 = 7,300 kg
Materials purchase budget in $ = 7,300 x 10 = $73,000
Labour budget in hours = 1,800 x 2 = 3,600
Labour budget in $ = 3,600 x $6 = $21,600
10
Overheads Budgets
VARIABLE PRODUCTION OVERHEADS BUDGET:
Variable production overheads budget - expected variable production overheads expenditure,

when the budgeted production volume is manufactured.
Standard variable production

Variable Budgeted labour hours/
overhead rate per labour hours /
production = machine hours / other x
machine hour / other allocation
overheads budget allocation basis
basis
FIXED PRODUCTION OVERHEADS BUDGET:
Fixed production overheads budget - expected expenditure on fixed production overheads

when the budgeted production volume is manufactured.
Standard fixed production

Budgeted labour hours/
Fixed production overheads rate per labour hours /
= machine hours / other x
overheads budget machine hours / other allocation
allocation basis
basis
Note: Both budgets are based on the information from the standard cost card.
11
EXAMPLE:
The standard cost card for Product X is as follows:
Cost $
Direct materials - 4 kg of Material B @ $10 per kg 40
Direct labour - 2 hours @ $6 per hour 12
Variable production overheads 2
Fixed production overheads 4
Total absorption cost 58
The business has budgeted to produce 1,800 units of Product X.
Calculate the following:
− Variable production overhead budget in $
− Fixed production overhead budget in $
Solution:
Variable production overhead budget in $ = $2 x 1,800 = $3,600
Fixed production overhead budget in $ = $4 x 1,800 = $7,200
12
Budgeted Statement of Profit or Loss
Budgeted statement of profit or loss = Estimate of earnings
Proforma of the budgeted statement of profit or loss:
Narrative Description $ $
Sales revenue Budgeted sales volume x budgeted selling price x
Opening inventory # of units x standard cost x
Production costs Budgeted production volume x standard cost* x
Closing inventory # of units x standard cost (x)
Production cost of sales (x)
Gross profit x
Non-production overheads (x)
Net profit x
*Production costs budget can also be calculated as follows:
Materials Variable
Production Labour Fixed production overheads
= usage + + production +
costs budget budget (in absorption costing only)
budget overheads
13
Example Budget Preparation
PROFORMA OF THE BUDGETED STATEMENT OF PROFIT OR LOSS:
Narrative Description $ $
Sales revenue Budgeted sales volume x budgeted selling price x
Opening inventory # of units x standard cost x
Production costs Budgeted production volume x standard cost* x
Closing inventory # of units x standard cost (x)
Production cost of sales (x)
Gross profit x
Non-production overheads (x)
Net profit x
Production costs budget can also be calculated as follows:
Materials Variable Fixed production

Production Labour
= usage + + production + overheads (in absorption
costs budget budget
budget overheads costing only)
The master budget includes:
− Budgeted statement of profit or loss
− Budgeted statement of financial position
− Budgeted statement of cash flows
14
EXAMPLE:
The standard cost card for Product XYZ is as follows;
Standard cost per

unit $
Direct materials (2 kg @ $2.50) 5
Direct labour (15 minutes @ $8 per labour hour) 2
Variable production overheads (1 machine hour @ $0.50 per machine

0.50
hour)
Fixed production overheads (1 machine hour at $1.50 per machine hour) 1.50
Total 9
In addition, the following information is relevant:
− The budgeted selling price is $25 per unit for sales of 10,000 units of Product XYZ
− Budgeted non-production overheads are $34,000
− Opening inventory of Product XYZ is 1,000 units
− The closing inventory of Product XYZ is 800 units
Prepare a budgeted statement of profit or loss for the business.
15
Solution:
$ $
Sales revenue - $25 x 10,000 250,000
Cost of sales
Opening inventory - 1,000 x $9 9,000
Production costs (10,000 + 800 - 1,000) - 9,800 x $9 88,200
Closing inventory 800 x $9 (7,200)
Cost of sales (90,000)
Gross profit 160,000
Non-production overheads 34,000
Net profit 126,000
16
Fixed Budgets
DEFINITION:
Fixed budget - the budget that is prepared for a fixed level of activity.
FIXED BUDGET PROFORMA:
Budgeted item Description Amount, $
Sales Expected number of units sold x Expected selling

x
price per unit
Direct materials Budgeted production x Quantity of material required

(x)
per unit of production x Standard material cost
Direct labour Budgeted production x Labour hours required per

(x)
unit of production x Standard labour cost per hour
Variable production Budgeted production x Labour hours worked per unit

overheads of production x Standard variable production (x)
overhead cost per hour*
Fixed production overheads Fixed amount not depending on the budgeted

(x)
production
Non-production overheads Fixed amount not depending on the budgeted

(x)
production
Profit X
* In case variable production overheads are linked to labour. Other calculation bases may be
considered.
Note: In practice, organisations are rarely able to estimate the number of units sold, so most
companies prepare budgets for more than one level of activity (flexible budgets).
17
Flexible Budgets
DEFINITION:
Flexible budget - a budget that shows revenues and expenditures of a company at different
activity levels.
FLEXIBLE BUDGET PROFORMA:
Amount, $ Amount, $
Budgeted item Description
X level of activity Y level of activity
Expected number of units sold x Expected x y

Sales
selling price per unit
Budgeted production x Quantity of material (x) (y)

Direct materials required per unit of production x Standard
material cost
Budgeted production x Labour hours required (x) (y)

Direct labour per unit of production x Standard labour cost
per hour
Variable Budgeted production x Labour hours worked (x) (y)

production per unit of production x Standard variable
overheads production overheads cost per hour*
Fixed production Fixed amount not depending on the budgeted (x) (y)
overheads production
Non-production Fixed amount not depending on the budgeted (x) (y)

overheads production
Profit X Y
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* In case variable production overheads are linked to labour. Other calculation bases may be
considered.
Note: Spreadsheets and “what if analysis” are very useful tools in preparing flexible budgets
quickly and accurately. In order to make a valid comparison of budgeted and actual results in
the case where the actual level of activity differs from that budget, it is necessary to flex the
original budget (prepare flexed budget).
ILLUSTRATION 1:
A company prepared a fixed budget for the period. At the fixed activity level of 1,750 units, the
budget is shown below:
Type of revenue/cost Fixed budget - 1,750 units
Sales revenue Variable (1,750 x $90) 157,500
Materials Variable (1,750 x $40) 70,000
Labour Variable (1,750 x $12) 21,000
Variable overheads Variable (1,750 x $2) 3,500
Fixed overheads Fixed - $7,200 7,200
Non-production overheads Fixed - $15,000 15,000
Profit 40,800
The same company then prepared a flexible budget to show the different costs and revenue at
three different activity levels as follows:
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1,750 units 1,925 units 2,100 units
$ $ $
Sales revenue 157,500 173,250 189,000
Materials 70,000 77,000 84,000
Labour 21,000 23,100 25,200
Variable overheads 3,500 3,850 4,200
Fixed overheads 7,200 7,200 7,200
Non-production overheads 15,000 15,000 15,000
Profit 40,800 47,100 53,400
20
Cash Budgets
Cash budget – A budget which details the estimated cash inflows and outflows.
Key features:
− Concerned only with cash receipts and payments;
− Non-cash items (like depreciation of fixed assets) are ignored in cash budgets;
− Cash items which are not shown in the PL (like a receipt for the sale of a fixed asset -
profit or loss on sale is only shown in the PL) are incorporated into the cash budget;
− Timing of cash flows is crucial in preparing the cash budget.
Common tips for preparing cash budgets:
1) Revenue is usually expected to be spread evenly unless otherwise stated;
2) Suppliers could be paid at the end or at the start of the month of purchase;
3) Labour is paid during the month of work;
4) Variable production overheads are paid during the month when they are incurred;
5) Fixed production overheads are paid during the month when they are incurred.
21
Cash budget proforma:
Quarter 1 Quarter 2 Quarter 3 Quarter 4
Sales receipts x x x x
Loan receipts x x x x
Sales of non-current assets x x x x
Total receipts x x x x
Materials x x x x
Labour x x x x
Variable overheads x x x x
Fixed overheads x x x x
Repayment of loans x x x x
Purchase of non-current assets x x x x
Total payments x x x x
Cash balance brought forward x x x x
Net cash inflow / (outflow) x x x x
Cash balance carried forward x x x x
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Example 1:
A Company budgeted to sell 1,750 units of Product X and to produce 1,800 units of Product X in
a given year. The following information has been budgeted:
− A sales revenue budget of $157,500. Sales revenue is expected to be spread evenly

throughout the year and all sales are cash sales.
− A material purchases budget of $73,000. Suppliers of materials are paid at the end of
the month in which the materials were purchased.
− A labour budget of $21,600. Labour is paid in the month in which the work is carried
out.
− A variable production overhead budget of $3,600. Variable production overheads are

paid in the month in which the overheads are incurred.
− A fixed production overhead budget of $7,200. Fixed production overheads are paid in
the month in which the overheads are incurred.
The company also took out an interest-free loan of $40,000 in Quarter 1 and repaid this loan in
full in Quarter 4.
In addition, the company purchased a new non-current asset for $25,000 in Quarter 2 and sold
the item of equipment that it was replacing in Quarter 3 for $2,000.
The cash balance brought forward at the beginning of Year 2 is $15,000.
Using this information, prepare a 4-quarter cash budget for the company.
23
Solution:
$ $ $ $
Sales receipts 39,375 39,375 39,375 39,375
Loan 40,000
Sale of a non-current asset 2,000
Total receipts 79,375 39,375 41,375 39,375
Materials 18,250 18,250 18,250 18,250
Labour 5,400 5,400 5,400 5,400
Variable overheads 900 900 900 900
Fixed overheads 1,800 1,800 1,800 1,800
Repayment of loan 40,000
Purchase of non-current asset 25,000
Total payments 26,350 51,350 26,350 66,350
Cash balance brought forward 15,000 68,025 56,050 71,075
Net cash inflow/(outflow) 53,025 (11,975) 15,025 (26,975)
Cash balance carried forward 68,025 56,050 71,075 44,100
24
Cash Budgets and “What If” Analysis
There could be a wide range of potential situations relating to cash budgets.
Spreadsheets and various functions and tools in them can be used to modify drivers, revenue,
expenses, and payroll assumptions.
What if analysis is the process of changing the values in cells to see how those changes will
affect the outcome of formulas on the worksheet. Examples of changes in cash budgets where
what if analysis can be helpful:
− Shift from purely cash sales to partial or full credit sales;
− Shift from purely cash purchases to partial or full credit purchases;
− Delay of loan repayment.
25
Cash budget proforma:
Sales receipts x x x x
Loan receipt x x x x
Sales of non-current asset x x x x
Total receipts x x x x
Materials x x x x
Labour x x x x
Variable overheads x x x x
Fixed overheads x x x x
Repayment of loan x x x x
Purchase of non-current asset x x x x
Total payments x x x x
Cash balance brought forward x x x x
Net cash inflow / (outflow) x x x x
Cash balance carried forward x x x x
26
Example 1:
A business has calculated the total receipts for four quarters to be as follows:
Sales receipts 10,000 11,000 12,000 13,000
Loan receipt 5,000 - - -
Sales of non-current asset 50,000 - - -
Total receipts 65,000 11,000 12,000 13,000
If the business decides to delay the sale of the non-current asset to Quarter 3 and the sale in
Quarter 2 turns out to be 50% lower, calculate the total receipts.
Solution:
Ideally, what-if analysis is performed with the help of a spreadsheet. You should attempt to do
the same in the spreadsheet.
Sales receipts 10,000 5,500 12,000 13,000
Loan receipt 5,000 - - -
Sales of non-current asset - - 55,000 -
Total receipts 15,000 5,500 67,000 13,000
27
Budgeted Statement of Financial Position
DEFINITION:
Budgeted statement of financial position details the assets and liabilities, and the share capital
and reserves of an organisation at the end of a budget period.
Budgeted statement of financial position proforma:
FS line item Description $ $
Non-current assets Net book value X
Current assets:
# units x unit cost (according to the selected

Inventory x
inventory valuation technique)
Usually % of total sales and depending on

Trade receivables x
credit terms offered to customers
Closing balance according to the cash

Cash x
budget
Total current assets X
Total assets X
Current liabilities:
Usually % of total purchases and depending

Trade payables (x)
on credit terms offered by suppliers
Other short-term liabilities Loans etc. (x)
Total current liabilities (X)
Total liabilities (X)
Net current assets Current assets - Current liabilities X
Net assets Total assets - Total liabilities X
28
Note: Other FS line items may be inserted into the budgeted statement of the financial position
depending on the scenario. Equity and retained earnings may also be included.
ILLUSTRATION:
Budgeted statement of financial position proforma:
FS line item Description $ $
Non-current assets Net book value 100,000
Current assets:
Inventory 5,000 X $6 30,000
Trade receivables 45,000
Cash 15,000
Total current assets 80,000
Total assets 180,000
Current liabilities:
-
Trade payables
30,000
Other short-term -
Loans etc.
liabilities 40,000
Total current liabilities -70,000
-
Total liabilities
130,000
Current assets - Current

Net current assets 10,000
liabilities
Net assets Total assets - Total liabilities 50,000
29
Budgetary Control
DEFINITIONS:
Flexed budget - a flexible budget revised at the actual activity level. A flexed budget is prepared
using the same proforma as for a flexible budget, but only for the actual level of activity.
Key points to remember: Variable expenses in a flexed budget are calculated similarly as for
the flexible budget. Fixed production and nonproduction overheads are not changed with the
level of activity, so remain the same.
VARIANCES:
Variances involve comparing the planned results with the actual results.
TYPES OF VARIANCES:
Favourable (F or Fav) Adverse (A or Adv)
− Actual results are better than budgeted − Actual results are worse than budgeted
results; results;
− Have positive value; − Have negative value;
CONTROL STAGE OF PLANNING AND CONTROL CYCLE:
This stage begins with the measurement of actual results. The actual results are then compared
with the flexed budgets. The variances are calculated and the significant variances are
investigated. The variances are also broken down into sub variances.
If uncontrollable variances are identified before the period-end, necessary adjustments are
made and the budgets are revised accordingly.
30
BUDGETARY CONTROL REPORT TEMPLATE:
Budgeted item Flexed budget Actual results Variances
Sales X Y Z-A/F
Cost of sales:
Direct materials (x) (y) z - a /f
Direct labour (x) (y) z - a /f
Variable production overheads (x) (y) z - a /f
Fixed production overheads (x) (y) z - a /f
Cost of sales (X) (Y) Z-A/F
Gross profit X Y Z-A/F
Non-production overheads (X) (Y) z - a /f
Net profit X Y Z-A/F
31
BUDGETARY CONTROL REPORT - ILLUSTRATION:
Budgeted item Flexed budget Actual results Variances
$ $ $
Sales 175,500 157,950 17,550 (A)
Cost of sales:
Direct materials (78,000) (70,200) 7,800 (F)
Direct labour (23,400) (27,300) 3,900 (A)
Variable production overheads (3,900) (4,095) 195 (A)
Fixed production overheads (7,200) (7,480) 280 (A)
Cost of sales (112,500) (109,075) 3,425 (F)
Gross profit 63,000 48,875 14,125 (A)
Non-production overheads (15,000) (14,800) 200 (F)
Net profit 48,000 34,075 13,975 (A)
32
Compounding
Interest – The amount earned when money is invested, or amount that it costs to borrow
money. There are two types of interest:
− Simple;
− Compound.
Compounding - reinvesting interest that is earned from a sum of money each year, so that the
interest earned earns further interest.
Compounding formula:
Types of interest:
1) Nominal interest - interest rate stated without compounding.
2) Effective interest - nominal interest rate expressed in terms of an annual rate

(compounded or annual percentage rate):
1 + R = (1 + rn)
Remember: Discounting is the opposite of compounding.
Example 1:
John deposits $2,000 in the bank for five years. The bank pays simple interest at a rate of 5%
per year. Calculate the total interest earned by John over the period of five years.
33
Solution:
Interest each year = $2,000 x 5% = $100
Total interest over five years = $100 x 5 = $500
Example 2:
John deposits $2,000 in the bank for five years. The bank pays compound interest at a rate of
5% per year. Calculate the total interest earned by John over the period of five years.
Solution:
FV = PV x (1+r)n
FV = 2,000 x (1+ 0.05)5
FV = 2,552.6
Interest = FV - PV
Interest = $2,552.6 - $2,000
Interest = $552.6
34
Discounting
DEFINITIONS:
Compounding - reinvesting interest that is earned from a sum of money each year, so that the
interest earned earns further interest.
Discounting is the process of determining the present value of a payment, or a stream of

payments, that is to be received in the future. Discounting is the opposite of compounding.
FORMULAE:
PV = FV / (1+r)n
Note: 1/(1+r)n = Discount factor. It can be found in discount factor tables as well.
EXAMPLE:
Steven is given a choice of receiving $11,000 now or $15,000 in five years’ time. Interest rates
are 10%. Determine which offer is more beneficial for Steven.
Solution:
We need to calculate the present value of $15,000 received in five years’ time. This value can
be compared with the current offer of $11,000 to determine which one is more beneficial.
PV = FV / (1+r)n
PV = $15,000 / (1+0.1)5
PV = $9,312.8
The present value of $15,000 is lower than $11,000. Therefore, it is beneficial for Steven to
accept $11,000 now.
35
Annuities
DEFINITION AND FORMULA:
An Annuity is a constant cash flow for a specified number of years. The present value (PV) of
an annuity is calculated using annuity factors (table).
PV of annuity = Annuity x Annuity factor
Important assumption: First cash flow is assumed to occur in one year’s time.
SCENARIOS:
First payment is made in one year’s time Calculate PV of annuity using the above formula.
First payment is made immediately (at Calculate PV of annuity by increasing the ordinary
time 0) annuity factor by 1 (AF + 1).
1) Calculate PV of annuity as if payments happen

during all years;
First payment is made in ‘n’ years’ time
2) Discount PV of annuity back using same % for n
years.
EXAMPLES:
Example 1:
Robyn receives $1,500 a year for ten years. Interest rates are 5%. Calculate the PV of the
annuity.
Solution:
PV of annuity = $1,500 x 7.722
PV of annuity = $11,583
Example 2:
36
Robyn receives $1,500 a year for ten years when interest rates are 5% and the first payment is
made in three years’ time. Calculate the PV of the annuity.
Solution:
Value of annuity in three years’ time = $1,500 x 7.722
Value of annuity in three years’ time = $11,583
PV of annuity now = $11,583 x 0.907
PV of annuity now = $10,506
37
Perpetuities
A perpetuity is a constant flow of cash which lasts forever. In order to calculate the present
value of perpetuity, we can use the following formula:
PV (perpetuity) = Constant cash flow / Interest rate
The present value of a perpetuity can also be calculated using the formula:
PV (perpetuity) = Perpetuity x Annuity factor
Annuity factor = 1 / Interest rate
SCENARIOS:
In order to calculate the present value of perpetuity when the first payment is made now (T0),
rather than in one year’s time, we use the following formula:
PV (from time zero) = Perpetuity x Annuity factor + Payment at time zero (T 0)
or
PV (from time zero) = Perpetuity x (Annuity factor + 1)
When the first payment is made in two years’ time (T2), the value of a perpetuity is calculated
as follows:
PV (perpetuity) = (Constant cash flow / Interest rate) x Discount factor (n=1)
EXAMPLES:
Example 1:
Robyn receives $1,500 a year in perpetuity when interest rates are 5%. Calculate the present
value of the perpetuity.
Solution:
PV of perpetuity = $1,500 / 0.05
PV of perpetuity = $30,000
38
Example 2:
Robyn receives $1,500 a year in perpetuity when interest rates are 5% and the first payment is
to be made now. Calculate the present value of the perpetuity.
Solution:
PV of perpetuity = $1,500 / 0.05
PV of perpetuity = $30,000
Value of first payment = $1,500
Total PV including first payment = $30,000 + $1,500
Total PV including first payment = $31,500
Example 3:
Robyn receives $1,500 a year in perpetuity when interest rates are 5% and that the first
payment is to be made in two years’ time. Calculate the present value of the perpetuity.
Solution:
PV of perpetuity in two years’ time = $1,500 / 0.05
PV of perpetuity in two years’ time = $30,000
PV of perpetuity now = $30,000 x 0.952
PV of perpetuity now = $28,560
39
Capital Investment Appraisal
DEFINITION:
Capital investment appraisal involves looking at the amount of money that it will cost to invest
in a project and the amount of money that is likely to be generated during the lifetime of the
project.
CASH FLOWS TO CONSIDER:
Only relevant cash flows should be considered - actual cash movements in or out of an
organisation:
1) Future costs / revenues;
2) Incremental costs / revenues.
All other costs are irrelevant.
Examples of relevant cash flows:
− The Initial cost of investing in a project
− Annual direct running costs
− Estimated annual income
− Potential cost savings
− Residual values
Incremental costs or revenues represent the increase in costs or revenues that arise as a direct
result of the decision to invest in a future project.
Past / sunk costs are not directly attributable to the decision.
40
CAPITAL INVESTMENT APPRAISAL STEPS:
− Identifying relevant cash flows
− Calculating net cash inflows or outflows
− Discounting to present value annual income
− Evaluating on the basis of NPV, IRR or any other DCF technique
41
Net Present Value
STEPS TO CALCULATE NPV:
− Identify relevant cash flows
− Include relevant cash flows in the NPV table
− Calculate net cash flows
− Identify PV of the cash flows based on the discount factor
− Calculate NPV
NPV PROFORMA:
Year (Initial Cash Cash Cash Net total cash inflow / Discount Present
outflow) / flow 1 flow ... flow n (outflow) factor at given value
Residual value %
0 (x)
1 x / (x) x / (x) x / (x) X / (X) r X / (X)
... x / (x) x / (x) x / (x) X / (X) r X / (X)
n x x / (x) x / (x) x / (x) X / (X) r X / (X)
Total NPV X / (X)
Key selection criteria: Invest in a project with the highest NPV.
Note:
Required rate of return = Target rate of return = Cost of capital
42
Example 1:
An organisation is considering investing in a project which will last for four years and which will
require the purchase of a new machine. Details of the new machine are as follows:
− The machine will cost $450,000 and will be depreciated at an annual rate of $95,000 in
the four years that the organisation will use it.
− Sales revenue of $150,000 in the first three years is forecast to be generated as a result
of purchasing the machine. In the fourth year, the sales revenue is expected to increase
by 20%.
− The annual running costs of the new machine are forecast to be $30,000.
− The machine is expected to be sold at the end of four years for $70,000.
The organisation’s required rate of return (or target rate of return) for potential new projects is
8%. Calculate the NPV.
Solution:
Year Investment and Sales Machine Net cash Discount PV

residual value revenue running costs inflow/outflo factor at 12%
w
$ $ $ $ $
0 (450,000) (450,000) 1.000 (450,000)
1-3 150,000 (30,000) 120,000 2.402 288,240
4 70,000 180,000 (30,000) 220,000 0.636 139,920
Net present value (21,840)
43
Internal Rate of Return
Internal rate of return (IRR) – The discount rate at which a net present value of a potential new
project is zero.
a * (B - A)
IRR = A +
a-b
where:
A - lower discount rate
B - higher discount rate
a - NPV at the lower discount rate
b - NPV at the higher discount rate
ILLUSTRATING IRR:
44
CHOICE RULES:
If IRR is higher than the target rate of

Accept project
return
If two or more projects have IRR higher

Select the project with the highest IRR
than the target rate of return
45
Payback
DISCOUNTED PAYBACK CALCULATION IN STEPS:
Payback is a capital appraisal technique which aims to establish a point in time at which
investment in a project has been paid back. Calculation of a discounted payback includes the
following steps:
1) Calculate discounted cash flows of a project;
2) Calculate cumulative cash flow at the end of each period;
3) Determine in which period the project becomes NPV-positive, from being NPV-negative;
4) Determine the exact point of time in this period by time-apportionment (assuming that
cash flows were spreading evenly throughout the year).
Discounted payback proforma:
Year Net cash inflow / outflow PV of net cash inflow / outflow Cumulative cash flow
1 X1 Y1 Y1
2 - ... X2 - ... Y2-... Y1 + Y2-...
n Xn Yn Y1 + Y2-... + Yn
Total Y
46
UNDISCOUNTED PAYBACK CALCULATION IN STEPS:
1) Calculate the cumulative undiscounted cash flow at the end of each period;
2) Determine in which period the project becomes positive, from being negative;
3) Determine the exact point of time in this period by time-apportionment (assuming that
cash flows were spreading evenly throughout the year).
Undiscounted payback proforma:
Year Net cash inflow / outflow Cumulative cash flow
1 X1 X1
2 - ... X2 - ... X1 + X2-...
n Xn X1 + X2-... + Xn
Total X
Note: Select the project with the shortest payback period.
47
Example 1:
The following table indicates the cash flows and the present value of the cash flows for a
specific project:
Year Net cash inflow/outflow at 8% Present value
$ $
0 (450,000) (450,000)
1-3 120,000 309,240
4 220,000 161,700
Net present value 20,940
Calculate the discounted payback period.
Solution:
Year Net cash inflow/outflow at 12% Present value Cumulative cash flow
$ $ $
0 (450,000) (450,000) (450,000)
1-3 120,000 309,240 (140,760)
4 220,000 161,700 (20,940)
140,760/161,700 x 12 months = 10.44 = 11 months
Discounted payback period = 3 years and 11 months
48
Budgetary Control and Reporting
Budgets are powerful evaluation tools. Actual results are measured against budgeted results.
Actual sales or activities rarely match the budget exactly. Budgets are flexed to match the
actual output and to find the variances between the actual and budgeted activities.
The reasons for variances must be found so that adverse trends are corrected and favourable
ones are exploited. Let’s look at an example:
Monsters Inc. has prepared a budget for the year ended December 20X6 (Fig. 1). In January, the
financial team put together the actual information.
Budgeted ('000) Actual ('000)
Units 40,000 60,000
Revenue $260,000 $300,000
Material $80,000 $96,000

Variable
Costs
Labour $65,000 $83,200
Contribution Margin $115,000 $120,800
Factory Overhead $30,000 $25,880

Fixed Costs
Office Expenses $15,000 $25,000
Operating Income $70,000 $69,920
49
Fig. 1
Management expected a higher income as more units were sold than they budgeted. However,
income was well below budget. A flexed budget will let you see why the income is lower than
expected. The variances between the flexed budget and the actual results are shown below
Budgeted ('000) Per Unit Flexed Budget ('000)
Units 40,000 1 60,000
Revenue $260,000 $6.50 $390,000
Material $80,000 $2 $120,000

Variable
Costs
Labour $65,000 $1.63 $97,500
Contribution Margin $115,000 $3 $172,500
Factory $30,000 $30,000 $30,000

Overhead
Fixed
Costs
Office $15,000 $15,000 $15,000
Expenses
Operating Income $70,000 - $127,500
50
Fig. 2
The flexed budget applies the budgeted amounts based on the actual output levels.
The budgeted variable costs per unit are calculated. This is done by dividing the budgeted
revenues and variable costs by the budgeted units. Then multiply this figure by the actual
output to get the flexed budget.
The fixed costs in the flexed budget don’t change. A fixed cost variance is the difference
between budgeted cost and the actual cost.
Actual ('000) Flexed Budget Variance ('000) Favourable /

('000) Unfavourable
Units 60,000 60,000 - -
Revenue $300,000 $390,000 ($90,000) Unfavourable
Material $96,000 $120,000 ($24,000) Favourable

Variable
Costs
Labour $83,200 $97,500 ($14,300) Favourable
Contribution Margin $120,800 $172,500 ($51,700) Unfavourable
Factory Overhead $25,880 $30,000 ($4,120) Favourable

Fixed
Costs
Office Expenses $25,000 $15,000 $10,000 Unfavourable
Operating Income $69,920 $61,500 $8,420 Unfavourable
51
Fig. 3
In Fig. 3 we can see the variances between the flexed budget and the actual results. These
variances are found by subtracting the budgeted amount from the actual results.
A variance can be:
− Favourable: A positive variance, for example, costs are less than expected.
− Unfavourable/Adverse: A negative variance reduces expected profitability. For example,

costs being more than budgeted.
− No variance: This is when the budget and the actual results match. This is good because
it means the company is meeting its targets.
Overall, the income was $8.4 million less than expected. That is 14% of the budgeted income,
which is significant.
52
VARIANCE ANALYSIS
Figure 4 is an analysis of the variances found in Monsters Inc. It provides possible reasons and
corrective action that can be taken. An accountant would be expected to make these
recommendations.
Variance Reason Action
All the variances in Variances can occur because of incorrect Setting a budget should be a
Monsters Inc. information used in the original budget. companywide exercise. The more
people involved and checking the
figures, the less likely a mistake will go
through.
Those responsible for an area, such as

department managers, should budget
the costs and be held responsible for the
information they provide.
An adverse This is due to reduced sales prices. Market research is needed to anticipate
revenue variance Perhaps because: competitors’ actions and consumer
trends which can then be budgeted.
− Competitors are offering lower

prices or consumers being The marketing team must communicate
unwilling or unable to pay the promotional activities and their impacts
budgeted price. on revenues and costs to the budgeting
team.
− Promotional offers such as buy
one get one free.
Favourable Reduced material costs could be due to: This is a favourable variance.
variance in
− Sourcing cheaper materials
materials cost
53
− Negotiating lower prices from The reasons for it should be found by
existing suppliers discussing with the production
managers.
− Buying larger quantities to get
discounts
− Using more efficient production Management should try to replicate

methods. these efficiencies found in other
departments.
The long-term impact of these actions

must be assessed.
Favourable Lower labour costs could be due to: This is a favourable variance.
variance in labour
− Reducing wages, i.e., a wage rate
cost
variance
The reasons for it should be found by
− Finding more efficient discussing with the HR managers.
production methods, i.e., a
labour efficiency variance
Management should try to replicate
− Mechanisation
these efficiencies found in other
departments.
The long-term impact of these actions

must be assessed.
Fixed costs have an The increase in the units sold could The reasons for this variance must be
unfavourable cause the fixed costs to increase in a found by looking at the individual
variance new range of products. breakdown of the expenses.
54
Fig. 4
RESPONSIBILITY ACCOUNTING
Responsibility accounting's objective is to accumulate costs and revenues for each individual
responsibility centre so the variances from the budgets can be attributed to an individual, like a
department head.
Responsibility accounting is based on the controllability principle. The controllability principle

states that people should only be held responsible for what they control. So, controllable and
uncontrollable costs must be identified. In business, this is not simple because many costs have
controllable and uncontrollable elements.
IDENTIFYING CONTROLLABLE AND UNCONTROLLABLE COSTS
The committee of cost concepts and standards in the United States published a report in 1956
with guidelines to identify uncontrollable and controllable costs. We can still use these
guidelines today.
1. If a manager can control the quantity and price paid for a product or service, then the
manager is responsible for all the expenditure incurred for that product or service.
2. If a manager can control the quantity of the service but not the price paid, then they
should only be responsible for the amount of difference between the actual and
budgeted expenditure that is due to the usage.
3. If the manager cannot control the quantity or the price paid, then this expense is
uncontrollable and should not be assigned to a manager.
However, in the real world, a general rule is to hold managers responsible for areas you want
them to pay attention to. If an employee believes a cost is uncontrollable, they will not be
motivated to take steps to reduce it. Sometimes an expense is uncontrollable but actions can
be taken to reduce its impact. For example, a manager cannot control what competitors do, but
they can take steps, like reducing sales price, to reverse the effects of this uncontrollable
circumstance.
55
CONTROL REPORTS
Regular control reports need to be given to the people responsible for the cost to implement
responsibility accounting.
− These reports will show the budgeted cost for their area, the actual cost, and the
variances.
− These reports, often monthly, enable managers to act on variances before the financial
year end.
The recommendations and reports should also include non-financial factors, for example, any
changes in product quality.
The F2 Syllabus requires students to be able to prepare control reports and give
recommendations to management.
Below is a control report for the Managing director (Fig. 5). It is an overall summary of the
variances in the company. The higher the management level, the less detail given. Costs are not
broken down like they are in the department manager's report (Fig. 6) or the cost centres
managers’ report (Fig. 7).
56
The Managing Director's monthly control report for January 20X6
Actual ('000) Flexed Variance ('000) Favourable /

Budget ('000) Unfavourable
For Jan Year to date
Units 5,000 5,000 - - -
Revenue $25,000 $32,500 ($7,500) ($7,500) Unfavourable
Material $8,000 $10,000 ($2,000) ($2,000) Favourable

Variable
Costs
Labour $6,933 $8,125 ($1,192) ($1,192) Favourable
Contribution Margin $10,067 $14,375 ($4,308) ($4,308)
Factory $2,157 $2,500 ($343) ($343) Favourable

Overhead
Fixed
Costs
Office $2,083 $1,250 $833 $833 Unfavourable
Expenses
Operating income $5,827 $10,625 ($4,798) ($4,798) Unfavourable
57
Fig. 5
The Office manager's monthly control report for January 20X6

Supervisors $1,000 $550 $450 $450 Unfavourable
Complaints Staff $733 $500 $233 $233 Unfavourable
Stationary $200 $100 $100 $100 Unfavourable
Phone and internet $150 $100 $50 $50 Unfavourable
Office expenses $2,083 $1,250 $833 $833 Unfavourable
58
Fig. 6
The Office manager's report breaks down the office expenses. Office expenses were one figure
on the Managing Director's report. This is the office manager's area of responsibility and he or
she should take actions to reduce these unfavourable variances.
The Complaints staff manager's monthly control report for January 20X6

Staff Count 20 19 - - -
Complaints Staff Salary $400 $450 ($50) ($50) Favourable
Complaints Staff Bonus $8 $10 ($2) ($2) Favourable

Overtime Week 1

Overtime Week 2

Overtime Week 3

Overtime Week 4
Complaints Staff $733 $500 $233 $233
59
Fig. 7
Figure 7 shows how detailed the information is for this cost centre. Non-financial information
like staff numbers is provided.
60
Budgeting and Behaviour
IMPORTANCE OF MOTIVATION ON PERFORMANCE:
Motivation:
Motivation is the desire to perform. We are all motivated by different desires and goals in life.
One key challenge for management is to create a system of performance management that
manages employee motivation and channels their effort towards helping to achieve
organisational goals. When the employees’ goals are aligned to the organisation’s, this is known
as ‘goal congruence’.
Without motivation, employees would be unproductive and the organisation would be unable
to meet its goals.
Budgets and motivation:
Budgets are a part of the overall performance management framework in the organisation, and
as such are used to help influence motivation. Let’s consider how budgeting impacts motivation
and behaviour.
Hopefully, having a target to aim for that the employee feels is challenging but achievable, and
that the employee feels they want to achieve (for example, if they earn a bonus by reaching the
target, or some other form of reward like a promotion) will mean they are motivated and will
work towards that target.
THE IMPACT OF PARTICIPATION IN THE BUDGET SETTING PROCESS:
However, sometimes budgets can actually have a negative impact on motivation. This could be
due to several reasons.
Top-down budgeting:
If those who set the budget are not responsible for reaching the target, the manager working
towards the target may feel they do not ‘own’ the target and may even reject it, especially if it
is unrealistic. Imposing a target on employees is known as ‘top-down budgeting’. Typically, with
top-down budgeting, senior management will dictate the targets and pass them down to
middle management.
61
Disadvantages of top-down budgeting:
Imposing budgets in this way can be problematic in many ways:
− The budget may end up being unrealistic, particularly if top management is a little ‘out
of touch’ with the detail of day-to-day operations. As a result, the budget may be too
easy or too difficult to achieve. Either could cause employees to underperform (too
easy: relax! Too difficult: give up!). In other words, the budget won’t motivate staff.
− It takes senior management time which might be better spent on other things. It also
limits the total mental effort going into the budgets to the senior management team,
the skills of middle management are under-utilised.
− Middle management may not feel emotional that the targets are ‘theirs’. This lack of
ownership limits motivation. A target you come up with yourself is more your
responsibility. If you miss that target, you can’t blame someone else for the target being
unrealistic!
Advantages of top-down budgeting:
A top-down approach does have some advantages:
− It is relatively quick; it does not take long for a small group of people to come up with
the target and merely communicate it to others.
− It may actually end up being more realistic, senior management is often very
experienced, are in touch with the needs of the wider stakeholder community (such as
shareholders and lenders), and will not build in budgetary slack to the budgets.
− Budgetary slack is a problem experienced when people are asked to come up with their
own targets. For example, if a manager asks an employee; ’how long will this job take?’,
the employee may think to themselves ‘probably 2 days but I’ll say 3 to give myself a bit
of a buffer in case anything goes wrong’. The extra day they have built in is known as
‘budgetary slack’, and is often a significant issue when employees are asked to prepare
their own budgets.
A top-down approach might be more appropriate in certain circumstances, for example:
− If a business is new, or very small, then the owner/manager might be best placed to set
targets as they probably know more than most about the plans of the business.
62
− In ‘tough times’, for example, if there are serious cash flow issues, sometimes targets
have to be imposed to ensure the survival of the business.
− Middle managers may not possess the necessary skills to put budgets together, so
senior management may have little choice.
Bottom-up budgeting:
The opposite of a top-down approach is known as bottom-up. With bottom-up budgeting,

middle management is asked to calculate their own budgets. They are then aggregated to give
the overall budget for the whole organisation. This is also known as ‘participative budgeting’.
Advantages of bottom-up budgeting:
Participation in this way may well improve motivation for several reasons:
− Targets were derived from those responsible for achieving them - there is likely to be a
stronger sense of ownership of them.
− They may be more realistic as middle managers are often closer to the detail and know
more about what to expect.
− It improves the skills of middle management if they get exposure to building budgets.
− It frees up senior management time to concentrate on other things.
Disadvantages of bottom-up budgeting:
However, bottom-up budgeting takes time and money, may build in the budgetary slack, and
may not add up to the targets that, for example, shareholders want!
Negotiated budgeting:
In many cases, a combination of top-down and bottom-up is used. often called ‘negotiated
budgeting’. Middle management may come up with initial targets that senior management
than ‘tighten’ through a series of negotiations. This process seeks to find a happy middle
ground of motivated managers with realistic, challenging but achievable targets.
63
ANTHONY HOPWOOD’S MANAGEMENT STYLES:
Anthony Hopwood considered the style management adopt when using budgets to manage a
business and the impact this has on behaviour. He identified 3 styles:
1. Budget constrained:
A budget constrained manager will see each line of a budget as an absolute limit and will strive
to stick within each aspect of the budget. This zealous approach may sometimes lead to
frustrating decisions.
For example, suppose the training budget has been spent for the year, but there is an
unexpected change in tax legislation that everyone needs training on so they can do their jobs.
A budget constrained manager may say ‘you can’t have the training; we don't have the budget’.
This can lead to frustration amongst staff, poor staff relations and poor motivation.
Hopwood also suggested that the budget constrained manager is also more likely to ‘massage’
reports, manipulate information to ensure they ‘look good’ in relation to the budget.
At times, however, it might be necessary to adopt this style, for example with dangerously low
cash flows, and so overspending may threaten the survival of the organisation.
2. Profit conscious:
A profit conscious style, in a sense, is a little more relaxed and balanced. The profit conscious
manager makes decisions that are good for profits overall.
In the previous example of a change in tax legislation, they would probably authorise the
training on the basis that it is good for profits overall.
Staff relations and motivation tend to be better with this style, and the manager themselves is
less likely to manipulate reports comparing budget to actual performance.
3. Non-accounting style:
A non-accounting style focuses on ‘doing a good job’. The ethos here is that ‘If I do the best job
I can, whatever the profits are, they are the best they could have been’. This type of manager
doesn’t particularly use budgets to guide decisions.
Staff relations may generally be good, but motivation may not be as focused on targeted
performance as perhaps it should be.
64
UNINTENDED CONSEQUENCES OF BUDGETING:
Budgets can have unintended consequences, like:
− Pressure groups may form. A pressure group is a group of people who collectively reject
the budget, almost like a rebellion, ‘everyone around here thinks the budgets are poor so
I’ll ignore them too!’
− They can create a blame culture when budgets are used to identify who is responsible for
poor performance. This in itself can create a negative and de-motivational working
environment.
− In a changing and unpredictable environment, targets will probably end up being

unrealistically high or unrealistically low. This is because the future is difficult to predict.
High or low targets both demotivate as we’ve already said!
CONTROLLABILITY AND MOTIVATION:
The issue of controllability also affects motivation. Care should be taken to ensure budgets
given to a manager relate to items they have control over. If they contain items that the
manager cannot control, this could seriously demotivate the manager.
For example, if an uncontrollable cost increases substantially and the manager is held to
account for this, as they had no control over it in the first place, they cannot take any corrective
action, and they will feel frustrated that they are being made responsible!
IMPACT OF INCENTIVE SCHEMES ON BEHAVIOUR:
Incentive schemes should be carefully designed to help motivate individuals appropriately. An

incentive scheme should seek to reward individuals for goal congruent performance. Ideally, it
should also be flexible to individual needs and desires, for example, a financial bonus may
incentivise some, but other benefits in kind may motivate others.
The targets to trigger incentives needs to be carefully considered, Colin Drucker (amongst
others) once said; ‘what gets measured gets done’, so setting the wrong targets in incentive
schemes can encourage the wrong types of behaviour. For example, paying a large bonus for
annual profit may encourage dysfunctional behaviour. A manager may cut back on training and
research and development to secure a bonus this year, but is actually damaging the long run
performance of the business.
65
Care needs to be taken to ensure incentive scheme targets reflect the short- and long-term
needs of the business.
SUMMARY:
− Ultimately the main reason to prepare budgets is to motivate employees to behave in a

goal congruent manner.
− Care, therefore, needs to be taken when designing the budget preparation process, and
the subsequent use of budgets, to ensure they are realistic and that the manager
responsible for them feels like they ‘own’ the target.
− The targets used in incentive schemes should be consistent with the budget targets of
the business to secure the individual’s motivation to behave appropriately.
66

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MA - Budgeting

Budget period - specified period for which future plan is written.

Budget time specifications:

1) Prepared during the planning stage of planning and control cycle;

2) Prepared before budgeting period starts;

Planning stage components:

− Estimation of revenues from products and services in the future period.

− Planning of spending the generated revenue.

− Budgeted statement of profit or loss;

− Budgeted statement of financial position.

STAGES IN THE BUDGET SETTING PROCESS:

1) Identify any limiting factors or principal budgeting factor;

2) Prepare individual budgets;

3) Review individual budgets;

4) Revise individual budgets where required;

5) Agree on final individual budgets;

6) Prepare budgeted statement of profit or loss;

7) Prepare cash budget;

8) Prepare budgeted statement of financial position;

9) Prepare master budget;

10) Compare actual and budgeted results (variances).

The formation of a budget committee is important for budget preparation.

Budget committee responsibilities:

− Preparing the budget manual;

− Coordinating the budgeting process;

− Approval of individual budgets.

Members of the budget committee:

− Member of the finance department.

Sales budget = Budgeted sales in units x Budgeted selling price

Material usage budget (or budgeted sales in units) x

Add: Closing inventory* x

Less: Opening inventory* (x)

Production budget in units X

Budgets, which can be prepared with the use of a production budget:

Sales budget = Budgeted sales in unit x Budgeted selling price

Sales budget = 2,000 x $150

Sales budget = $300,000

Budgeted sales 2,000

Add: Closing inventory 300

Less: Opening inventory (200)

Production budget in units 2,100

There are two types of materials budget:

− Materials usage budget

− Materials purchase budget

Materials usage Budgeted Quantity of material to make Standard

Materials purchases budget:

Description Units of material

Material usage budget x

Less opening inventory (x)

Material purchases budget X

Cost of material purchase in $ = Material purchases budget x Standard cost*

The standard cost card for Product X is as follows:

Direct materials - 4 kg of Material B @ $10 per kg 40

Direct labour - 2 hours @ $6 per hour 12

Variable production overheads 2

Fixed production overheads 4

Total absorption cost 58

Calculate the following: