Question 2

SunPower Ltd manufactures, sells, and installs solar panels that are sold to domestic
customers. The industry is highly competitive, and the management team reviews the
company's performance on a monthly basis. The trainee Management Accountant has
therefore produced a comparison of budgeted and actual performance for April and this is shown
below:

Comparison of budgeted and actual performance for April

Budget Actual

Sales volume (units) 1,300 1,180

£ £

Sales revenue 383,500 348,100

Direct material 104,000 91,450

Direct labour 71,500 70,800

Production overheads 55,750 55,100

Selling & installation costs 109,750 95,280

Administration costs 26,500 26,800

Profit 16,000 8,670

Production overheads and administration costs are believed to be fixed, whereas selling and
installation costs are semi-variable. The selling and installation cost budget was set by taking
appropriate information from the results for the last three months of 2019, which are shown below:

Selling and installation costs

Sales (units) Total cost (£)

October 1,250 106,000
November 1,550 128,500
December 1,400 118,500
The Finance Director is concerned that the selling and installation costs budget may have been
padded, but the Installation Manager complained that the budget includes costs that she does not
control.

Required

a) Explain what a budget is and state THREE reasons why companies produce budgets.

ANSWER:

A budget is an operations and resources plan of a company , which is formulated to achieve

the proposed objectives in a certain period and is expressed in monetary terms. In other words,
budgeting is simply planning what you want to do in the future and expressing it in money. The
budget is a document that foresees the costs and profits of a certain body, company, or entity,
be it private or state, in a certain period. Official budgets must meet four requirements, on the
one hand the preparation, then it must be approved by the corresponding body, it is executed
and finally there must be a control. When it comes to state budgets, they are regulated by law.

Companies produce quotes for the following main reasons:

1) Carry out controls about purchases, sales, quantify income and money expenses, review the
tactics and policies taken by the organizations.

2) Prevent and correct mistakes, measure risk and reduce it.

3) Carry out the financial controls of the entity, plan the operations and later continue with this
planning.

b) Calculate the selling and installation costs by using high-low method, with brief
explanations of the method you use.

ANSWER:

The high-low method is a cost segmentation method in accounting for the separation of the
fixed and variable components present in mixed or semi-variable costs. This method is based on
estimating the fixed part and the variable part of the cost at two different levels of activity; These
parts are calculated through an arithmetic interpolation between the two different levels assuming
a linear behavior. The straight line to be estimated represents the Cost - Activity Level
relationship. The two points that are selected to define the line are the highest and lowest point of
activity. The slope of the line shows the variable rate of cost.
High Low Method (Computation)

Highest Activity Cost = 128,500

Lowest Activity Cost = 106,000

Highest Activity Units = 1,550

Lower Activity Units = 1,250

Variable Cost Per Unit = (Highest Activity Cost – Lowest Activity Cost) / (Highest Activity Units –
Lowest Activity Units)

= (128,500 – 106,000) / (1,550 – 1,250)

= 22,500 / 300

= 75

Fixed Cost = Highest Activity Cost – (Variable Cost Per Units * Highest Activity Units)

= 128,500 – (75 * 1,550)

= 128,500 – 116,250

= 12,250

Fixed Cost = Lowest Activity Cost – (Variable Cost Per Units * Lowest Activity Units)

= 106,000 – (75 * 1,250)

= 106,000 – 93,750

= 12,250

c) Produce a performance statement for April using flexible budgeting principles. All
calculations must be clearly shown.

ANSWER:

Flexible Budget
Varianc
Particulars Budget Actual Favorable/Unfavorable
e
Sales volume (units) 1,300 1,180
£ £
Sales revenue 383,500 348,100 35,400 Favorable
Cost:
Direct material 104,000 91,450 12,550 Favorable
Direct labour 71,500 70,800 700 Favorable
Production overheads 55,750 55,100 650 Favorable
Selling & installation 109,750 95,280 14,470 Favorable
costs
Administration costs 26,500 26,800 (300) Unfavorable
Total overhead 367,500 339,430 28,070 Favorable
 Profit 16,000 8,670 7,330 Favorable

Formulas:

d) Explain what "padding the budget" involves and why it might occur.

ANSWER:

"Padding the budget" is to apply the budget slack. It occurs when a manager
deliberately underestimates revenue, overestimates costs, and requests more funds than
necessary to support the budgeted level of activities. It is the difference between the
projections of income or costs that a person provides and a realistic estimate of the income
or costs of the company.

Subordinate managers may know , based on past experiences, that their budget
proposals will be shortened by senior managers, and therefore they will be tempted to cover
certain expenses or make low-income estimates. In contrast, senior managers who are aware
of the filling habits of their subordinate managers may be tempted to increase the level of
expected income and reduce budgeted expenses. Similarly, sales managers underestimate
their sales projections; the controller introduces slack by maintaining excessive cash
balances, etc. The degree of slack tends to grow in good years, when satisfactory profits are
easily achievable, in bad years slack is voluntarily reduced throughout the organization.

There are three main reasons to fill the budget or budget slack. First, people often perceive
that their performance will look better in the eyes of their superiors if they can "go over
budget."

Second, the budget stack is often used to deal with uncertainty. However, the supervisor
may also feel that some unforeseen event during the budget period could result in
unforeseen costs. One way to deal with that unforeseen event is to budget. If nothing goes
wrong, the supervisor can exceed the cost budget. If a negative event occurs, the supervisor
can use the budget margin to absorb the impact of the event and still meet the cost budget.

The third reason cost budgets are filled in is that budget cost projections are often cut in the
resource allocation process. Thus, there is a vicious cycle. Budget projections are filled in
because they are likely to be trimmed, and they are trimmed because they are likely to have
been filled in.

e) Discuss whether managers should be evaluated based only on costs and revenues that they
control.

ANSWER:

Managers should not be evaluated solely on the costs and revenues that they control. A correct
evaluation of business management suggests an integral analysis of the results in different aspects:
economic, financial, patrimonial, and productive, among others, being the sense of its
implementation to find information that allows to improve the management processes. There are
different methodological proposals for the evaluation of business management, which coincide in
highlighting as main actions the collection of data, the calculation of results, the analysis of
information, the preparation of conclusions and recommendations.