Chapter Three

Information for budgeting, planning & control purposes

Definition of budget
 Budget is the quantitative expression of a proposed plan of action by management for a
future time period and is an aid to the coordination and implementation of the plan.
 Budget is a financial or quantitative statement prepared prior to a specified accounting
period, containing the plans and policies to be pursued during that period.
 Budget is a detailed plan, expressed in quantitative terms, that specifies how resources will
be acquired and used during a specified period of time.
 A budget generally includes both financial and nonfinancial aspects of the plan, and it serves
as a blueprint for the company to follow in an upcoming period.
Budgeting as a multipurpose activity

Activity-based budgeting (ABB) is an alternative budgeting practice. Traditional methods are

more simplistic, adjusting prior period budgets to account for inflation or revenue growth.
Rather than using past budgets to calculate how much a firm will spend in the current year,
activity-based budgeting (ABB) digs deeper.

Activity-based budgeting (ABB) is not necessary for all companies. For example, established
firms that experience minimal change typically find that applying a flat rate to data from the
previous year to reflect business growth and inflation is sufficient.

In contrast, newer companies without access to historical budgeting information cannot consider
this an option. Activity-based budgeting (ABB) is also likely to be implemented by firms
undergoing material changes, such as those with new subsidiaries, significant customers,
business locations, or products. In these types of cases, historical information may no longer be a
useful basis for future budgeting.

 Activity-based budgeting (ABB) is a method of budgeting where activities that incur

costs are recorded, analyzed and researched.
 It is more rigorous than traditional budgeting processes, which tend to merely adjust
previous budgets to account for inflation or business development.
 Using activity-based budgeting (ABB) can help companies to reduce costs and, as a
result, squeeze more profits from sales.
 This method is particularly useful for newer companies and firms undergoing material
changes.
  Using activity-based budgeting (ABB) can help companies to reduce the activity
levels required to generate sales. Eliminating unnecessary costs should boost
profitability.
The activity-based budgeting (ABB) process is broken down into three steps.

1. Identify relevant activities. These cost drivers are the items responsible for incurring
revenue or expenses for the company.
2. Determine the number of units related to each activity. This number is the baseline for
calculations.
3. Delineate the cost per unit of activity and multiply that result by the activity level.

Example of Activity-Based Budgeting

Company A anticipates receiving 50,000 sales orders in the upcoming year, with each
single order costing $2 to process. Therefore, the activity-based budget (ABB) for the
expenses relating to processing sales orders for the upcoming year is $100,000 ($50,000
* $2).
This figure may be compared to a traditional approach to budgeting. If last year’s budget
called for $80,000 of sales order processing expenses and sales were expected to grow
10%, only $88,000 ($80,000 + ($80,000 * 10%)) is budgeted.

Advantages and Disadvantages of Activity-Based Budgeting

Activity-based budgeting (ABB) systems allow for more control over the budgeting process.
Revenue and expense planning occurs at a precise level that provides useful details regarding
projections. ABB allows for management to have increased control over the budgeting process
and to align the budget with overall company goals.

Unfortunately, these benefits come at a cost. Activity-based budgeting (ABB) is more expensive
to implement and maintain than traditional budgeting techniques and more time consuming as
well. Moreover, ABB systems need additional assumptions and insight from management, which
can, on occasion, result in potential budgeting inaccuracies.

Behavioral Aspects in Budgeting

How the budget is administrated will affect their effectiveness and efficiency in achieving the
organization’s goals. Besides using budget to forecast the organization’s coming year’s
performance, it also serves another purpose. It can be used as a performance evaluation on the
managers’ actual performance against the budgeted performance. By doing so, the organization
is trying to use budget as a tool for control. When the performance evaluation is linked with any
form of rewards and penalty system, there are possibilities that the managers will distort any
information and data passed to upper level of management (i.e. their superiors). The managers
may underestimate the revenue, over-estimate the costs required. It can have an effect on their
job performance, which will be reflected on their annual appraisals. All these will affect their
salary increment, annual bonus, chances of promotion etc.
Below are the behavioral aspects of budgeting, which will arise:
Dysfunctional Behavior; when the budget’s goals are the same as managers’ goals, the actual
performance will meet the expected level of performance or even exceed the expectations. This
is called goal congruence. It refers to the alignment and consistency of individual’s goals (in this
instance, it is the manager) with the organizations’ goals. The managers will be motivated to aim
for the goals of the organization, as this will also lead them towards their individual goals. In the
case of goal incongruence, the managers are not motivated at all. They may put in minimum
efforts (in worst case scenario, no efforts from the managers) towards the budget, thus affecting
the actual performance. Adverse effect on his job appraisal.
Participative Budgeting; Budget is usually prepared either top down or bottom up. Under the
top-down budget method, top management prepares the budget and pass on the information to
the employee as what they need to do in the budget. There is no involvement and communication
from other employee. When there is participation from the employee, they become involved in
the budgeting process. They form part of the budget.

Budgetary Slack; The difference between the allocated resources and the actual required
resources is the budgetary slack. The managers introduce the budgetary slack, also known as
padding the budget, during the budget preparation process. They will underestimate the revenues
and overestimate the costs and expenses. In this way, they can request for more allocation of
resources from the organization. There is a tendency for the managers to do in almost all
organizations, across industries.
Quantitative aids in budgeting: learning curve theory and application; limiting factors and
linear programming,
Analyzing Fixed and Variable Cost

Two important quantitative methods the management accountant can use to analyze fixed
and variable cost elements from total cost data are the high-low and regression methods.

The high-low method

A method of analyzing a semi-variable cost into its fixed and variable elements based on an
analysis of historical information about costs at different activity levels.

The steps of high-low method

Step 1: Select the highest and lowest activity levels, and their costs.

(Note: do not take the highest and lowest cost).

Step 2: Find the variable cost per unit.

 Cost at high level of activity – Cost at low level of activity

High level activity – Low level activity

Step 3: Find the fixed cost, using either the high or low activity level.

Fixed cost = Total cost at activity level – Total variable cost

The high-low method has the enormous advantage of simplicity. It is easy to understand and easy
to use.

The limitations of the high-low method are:

(a) The method ignores all cost information apart from at the highest and lowest
volumes of activity.

(b) Inaccurate cost estimates may be produced as a result of the assumption of a

constant relationship between costs and volume of activity.

(c) Estimates are based on historical information and conditions may have changed.

Example 1

Cost data for the six months to 31 December 2011 is as follows:

Month Units Inspection costs

$
July 340 2,240
August 300 2,160
September 380 2,320
October 420 2,400
November 400 2,360
December 360 2,280

The variable element of a cost item is estimated calculating the unit cost between high
and low volumes during a period.

Units Inspection costs

 $
Highest level 420 2,400
Lowest level 300 2,160
Difference 120 240

Variable cost per unit = $240 ÷ 120 = $2 per unit

Fixed inspection costs are, therefore:

$2,400 – (420 units × $2) = $1,560 per month
Or $2,160 – (300 units × $2) = $1,560 per month

i.e. the relationship is of the form y = $1,560 + $2x

Linear regression analysis

Regression involves using historical data to find the line of best fit between two variables (one
dependent on the other), and use this to predict future values.

Linear relationships

(a) A linear relationship can be expressed in the form of an equation which has
the general form: y = a + bx

Where y is the dependent variable, depending for its value on the value of x,
e.g. the total costs

x is the independent variable, e.g. units

a is a constant, e.g. fixed cost

b is a constant, e.g. variable cost

(b) To find the line of best fit we need to calculate a and b using the historical
data for x and y. The formulae for these are:

n xy   x  y
b
n x 2   x 
2

a
 y  b x
n n
 Where n is the number of pair of data for x and y.

2.3.3 Example 2

A company has recorded expenditure on advertising and resulting sales for six months as follows:

Month Advertising Sales

expenditure
X Y
$ $
March 20 170
April 40 240
May 50 260
June 60 300
July 30 220
August 40 250

Required:

(a) Plot the data on a scatter diagram and comment.

(b) Calculate the line of best fit through the data, and interpret your values of a and b.
(c) Forecast sales when advertising expenditure is:
(i) $50,000
(ii) $100,000
and comment on your answers.

Solution:
(a)
There appears to be a positive linear relationship between advertising expenditure and sales.

(b)

X Y Xy x2 y2
20 170 3,400 400 28,900
40 240 9,600 1,600 57,600
50 260 13,000 2,500 67,600
60 300 18,000 3,600 90,000
30 220 6,600 900 48,400
40 250 10,000 1,600 62,500
240 1,440 60,600 10,600 355,000

6  60,600  240  1,440

b 3
6  10,600  240 2
1,440 3  240
a   120
6 6
The line is: y = 120 + 3x

This means that when advertising expenditure is zero, sales will be $120,000, and for every $1
spent on advertising, sales will increase by $3.

(c)(i)
Sales = 120 + (3 × 50) = 270
Forecast sales are $270,000
This is an interpolation within the sample range of values and is likely to be fairly accurate.
(c)(ii)
Sales = 120 + (3 × 100) = 420
Forecast sales are $420,000
This is an extrapolation outside the sample range and may be inaccurate.
A company has recorded expenditure on advertising and resulting sales for six months as follows:

Month Advertising Sales

expenditure
X Y
$000 $000
March 20 170
April 40 240
May 50 260
June 60 300
July 30 220
August 40 250

Required:

(a) Plot the data on a scatter diagram and comment.

(b) Calculate the line of best fit through the data, and interpret your values of a and b.
(c) Forecast sales when advertising expenditure is:
(i) $50,000
(ii) $100,000
and comment on your answers.

Solution:
(a)
There appears to be a positive linear relationship between advertising expenditure and sales.

(b)
X Y Xy x2 y2
20 170 3,400 400 28,900
40 240 9,600 1,600 57,600
50 260 13,000 2,500 67,600
60 300 18,000 3,600 90,000
30 220 6,600 900 48,400
40 250 10,000 1,600 62,500
240 1,440 60,600 10,600 355,000

6  60,600  240  1,440

b 3
6  10,600  240 2
1,440 3  240
a   120
6 6
The line is: y = 120 + 3x

This means that when advertising expenditure is zero, sales will be $120,000, and for every $1 spent
on advertising, sales will increase by $3.

(c)(i) Sales = 120 + (3 × 50) = 270

Forecast sales are $270,000
This is an interpolation within the sample range of values and is likely to be fairly accurate.
(c)(ii) Sales = 120 + (3 × 100) = 420
Forecast sales are $420,000
This is an extrapolation outside the sample range and may be inaccurate.

The strength of the linear relationship between the two variables (and hence the
usefulness of the regression line equation) can be assessed by calculating the correlation
coefficient (“r”) and the coefficient of determination (“r2”), where

n xy   x  y
r
n x 2

  x  n y 2   y 
2 2

If the degree of association between the two variables is very close, it will be almost possible to
plot the observations on a straight line, and r and r2 will be very near to 1. In this
situation a high correlation between costs and activity exists.

At the other extreme, costs may be so randomly distributed that there is little or no
correlation between costs and the activity base selected. The r2 calculation will be near
to zero.

Example 3

Using the date from Example 2 above:

6  60,600  240  1,440

r  0.97849
6  10,600  240 6  355,000  1,440 
2 2

r 2  0.957

Thus 95.7% of the observed variation is sales can be explained as being due to changes in the
advertising spending. This would give strong assurances that the forecasts made using the
regression equation are valid.
Budgetary control:
·Budgetary Control is a method of managing costs through preparation of budgets. Budgeting is
thus only a part of the budgetary control.
A control technique whereby actual results are compared with budgets. Any differences
(variances) are made the responsibility of key individuals who can either exercise control action
or revise the original budgets.
The main features of budgetary control are:
• Establishment of budgets for each purpose of the business.
• Revision of budget in view of changes in conditions.
• Comparison of actual performances with the budget on a continuous basis.
• Taking suitable remedial action, wherever necessary.
• Analysis of variations of actual performance from that of the budgeted performance to know
the reasons thereof.
Budgetary control and responsibility centers; These enable managers to monitor
organizational functions.
A responsibility center can be defined as any functional unit headed by a manager who is
responsible for the activities of that unit.
There are four types of responsibility center’s:
a) Revenue centers Organizational units in which outputs are measured in monetary terms but are
not directly compared to input costs.
b) Expense centers Units where inputs are measured in monetary terms but outputs are not.
c) Profit centers where performance is measured by the difference between revenues (outputs)
and expenditure (inputs). Inter-departmental sales are often made using "transfer prices".
d) Investment centers where outputs are compared with the assets employed in producing them,
i.e. ROI.
Type of budget
Based on budgeting strategies:-
1. Mandated Budgeting:-It relies on predetermined standards set by upper level managers for
its budget levels. It is also known as top-down budgeting because top management develops
the budget and passes them down the organizational hierarchy to various divisions and/or
departments without input from lower levels of management and employees.
2. Participative budgeting: - It allows individuals who are affected by the dub get to have
input into the budgeting process. It also known as button-up budgeting because the budgeting
process begins at lower levels of the organizational hierarchy and continues up through the
organization to top management. This budgeting strategy is beneficial in that most people
will perform better and make greater attempts to achieve a goal if they have been consulted
in setting the goal. Such participation can give employees the felling that “ this is our
budget,” rather than this is the budget you imposed on us.
3. Incremental Budgeting: - is a strategy whereby the company uses the current period’s
budget as a starting point in preparing the next period’s budget. In the traditional approach to
budgeting, the manager starts with last year’s budgets and adds to or subtracts from it
according to anticipated needs. This is an incremental approach to budgeting in which the
previous year’s budgets is taken for granted as a baseline.
4. Zero-Based Budgeting: - is a strategy in which the company begins each budget period with
a zero budget and requires consideration of every activity undertaken by the department or
segment. Zero based budgeting is alternative approach that is sometimes used particularly in
the governmental and not for profit sectors of the economy. Under a zero base budget,
managers are required to justify all budgeted expenditures, not just changes in the budget
from the previous year. The zero base budgeting approach forces management to rethink
each phase of an organizations operations before allocating resources. In zero base budgeting
there is no “givens”. It stars with the basic premise that the budget for next year is zero and
that every expenditure, old or new, must be justified on the basis of its cost and benefit.
Classification of Budgets According to Time: According to this classification, budgets are
divided in the following categories.
1. Short Term Budget: Any budget that is prepared for a period up to one year is known as
Short Term Budget. Functional budgets are normally prepared for a period of one year
and then it is broken down month wise.
2. Medium Term Budget: Budget prepared for a period 1-3 years is Medium Term Budget.
Budgets like Capital Expenditure, Manpower Planning are prepared for medium term.
3. Long Term Budgets: Any budget exceeding 3 years is known as Long Term Budgets.
Master Budget is normally prepared for long term. In the modern days due to uncertainty,
very few budgets are prepared for long term.
Based on capacity:
Based on the capacity, budgets are classified as fixed and flexible budgets.
1. Fixed Budgets: A flexible budget is one which will remain unchanged immaterial of the
level of activity these budgets are prepared for fixed expenses and their aim is to control cost.
A fixed budget is rigid and does not change with the volume of activity achieved. A fixed
budget is prepared for a particular level of activity and for a particular set of conditions. It is
prepared under the premise that there will be no change in the outside conditions.
2. Flexible Budgets: These budgets will change with the change in activity these budgets are
prepared for various level of activity. While preparing flexible budgets the expenses are
broadly classified as fixed, variable and semi-variable expenses.
A flexible budget can be changed to suit the level of activity to be achieved. Flexible budget is
not rigid. Flexible budgets are prepared for various levels of activities.
Based On Time
Though budgets may cover long periods (called long-range budgets), the most frequently used
budget period is one year (short-range budgets). The annual budget is often subdivided by
months for the first quitter and by quarters for the remainder of the year.
Companies are increasingly using rolling budgets. A rolling budget is always available for a
specified future period by adding a period (month, quarter, or year) in the future as the period
just ended is dropped. Rolling budgets are sometimes called revolving budgets or continuous
budgets. Therefore continuous (rolling) budget is a budget system that has a budget for a set
number of months, quarters, or years at all times–as one period ends another is added
Based on coverage
On the basis of coverage, budgets are classified as functional and master budget.
i. Functional budgets
It represents the budgets that relates to the various functional activities of an organization.
Functional budgets are classified as physical budgets, profit budgets, cost budgets and financial
budgets.
ii. Master budgets
Activity: What is master budget?
Definition: Master budgets are the consolidated summary of various functional budgets. It is the
aggregation of all lower-level budgets produced by a company's various functional areas, and
also includes budgeted financial statements, cash forecast, and a financing plan. The master
budget is typically presented in either a monthly or quarterly format, or usually covers a
company's entire fiscal year.
A master budget is the central planning tool that a management team uses to direct the activities
of a corporation, as well as to judge the performance of its various responsibility centers.
Thus budget represents the “grand plan of action” for an upcoming period and translates the
organization’s short-term objectives into action.