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					Lecture 5

Operating Budgets
(a) The Budgeting Process • Short term budgets • Intermediate term budgets • Long term budgets The Master Budget Operational Budgeting Incentives for Accurate Forecasts

(b) (c) (d)

(a)

The Budgeting Process

Budgets are a quantitative representation of management expectations of business operations for a future period of time. Budgets may be classified according to the time frame to which it relates, and generally speaking may be classified into : (i) Short term budgets to cover periods up to one year, which may be broken down into smaller periods. Short-term budgets represent expectations in relation to current business operations. They relate to the firm as it exists today. It is at the micro level. to cover periods from 6 months to 3 years, relating to the current business operations of the firm, and may include capital budgeting techniques. These budgets represent management expectations of existing business operations and any changes to operations that are to be instituted in the near future, for example, mechanisation of production, replacement of equipment, entry into new markets, new products etc. which range from 3 - 10 years and outline management’s expectations for the firm in the long term. Long term budgets are strategic statements of management’s' expectations of business operations in the distant future. They consider macro situations in terms of placement of the business and its operations in the medium to long term future. For example, a gold mining company with proven reserves for 5 years, may need to find other business ventures if it wishes to remain in existence. Basically, long term budgets aim to evaluate: (i) technological innovations (ii) economic climate (iii) business opportunities as it is expected to affect the firm and its business.

(ii) Intermediate term budgets

(iii) Long term budgets

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Budgets are formulated on the basis of a statement of objectives for the firm. The objectives may be stated as: • • profitability, return on total assets or return on shareholders funds, etc. profitability coupled with performance measures such as penetration of new markets, development of new products etc.

The objectives are the end result, with the budgets providing the stepping stones outlining the activities that need to be completed for the achievement of the predetermined objectives. This topic focuses on short-term operating budgets up to 1 year. Short term planning / budgeting quantitatively state management's plan of action for the coming year. They are used to guide operations and allow managers to compare actual results of operations with budgets to derive variances so as to enable performance evaluation.

Uses of Operating Budgets
Budgets are useful tools for : (1) planning, (2) control, and (3) employee motivation.

(1) Tool for Planning
After management selects the best alternatives for products, prices, levels of output, production techniques, and so on, it translates these choices into a formal, integrated plan of action. Budgets are estimates of physical operations the results of which are expressed in monetary terms in forecasted financial statements. They represent management expectations of transactions for the coming period.

(2) Tool for Control
Budgets provide estimates of expected performance. As such, they serve as standards for evaluating performance. Comparing budgeted and actual amounts provides a basis for evaluating past performance and guiding future action. To be effective as tools for control, the firm must initially develop its budgets for individual responsibility centers. The firm develops budgets for production, marketing, purchasing, administration and so on. Then the firm integrates these separate budgets into a master budget for the firm as a whole. In this way, top management can evaluate the performance of each responsibility center with respect to those activities over which it had control during a particular period. Flexible Budgets used as tools for control are generally flexible.. The "flex" in a flexible budget concerns the variable costs (that is, those costs that vary with changes in activity levels). The budget for fixed costs is static. Flexible Budget Formula = Fixed Cost + (Variable Cost per Unit * Units of Activity)

(3)

Tool for Employee Motivation

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The human factor is important in the planning and control process. Standards or budgets can motivate employees if the firm sets standards at levels that are tight but currently attainable with reasonably efficient performance. The budget of expected costs for planning purposes may differ from the standard costs that will best motivate employees. This instance is another in which budgeting and managerial accounting systems must adapt to serve multiple purposes.

(b)

The Master Budget

The master budget is a complete blueprint of the planned operations of the firm for a period. It emphasises the relation of the various inputs in all areas of the company to final output and sales. Master budget preparation requires recognising the interrelations among the various units of a firm. For example, to prepare a master budget requires knowing how a projected increase in sales of product A affects the several producing departments; the selling, general, and administrative effort; and the financial position of the company. Preparing a master budget requires time and effort by staff and management at all levels. Despite this difficulty, or perhaps because of it, management can effectively use the master budget as an instrument for planning and control. Almost all organisations recognise the importance of master budget preparation as an aid to management.

Classification of Budgets:
Budgets can be classified under the following three groups: 1. Fixed or Static Budgets: 2. Multiple Level Budgets: 3. Flexible Budgets: a budget prepared for a single volume of sales and production. is a budget prepared for several different volumes of sales and production. are budgets constructed so as to provide a ready means of computing budget figures for any particular level of volume, thereby establishing the means for direct, comparison of the actual operating results achieved, to the budget for that activity level.

A budget should possess a degree of flexibility if it is to be a worthwhile control tool. A fixed or static budget, loses much of its value if the set of conditions on which it was based alter to any extent hence the development of flexible budgets.

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Master Budget Framework
Performance budgets are known as profit plans. Resource budgets (or financial budgets) are known as statements of projected financial position. The complete set of component budget schedules is the master budget comprising of four major parts :
OPERATING BUDGETS • Sales • Production · Materials · Labour · Overhead • Inventory • Cost of Goods Sold • Profit & Loss · Other Income · Expenses CASH BUDGETS PROJECTED FINANCIAL STATEMENTS • Balance Sheet • Cash Flows CAPITAL EXPENDITURE BUDGETS • Fixed Assets • Product R & D • New Markets

• Receipts • Payments

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Master Budget Operations
The steps involved and the structure of the budgeting process may be illustrated as follows : Plan of Operations Management Goals & Objectives
formalised in

Annual Profit Plan
where management specifies

Overall Profit Objective
detailed in

Sales Budget Less

Other Income Budget

Overall Cost / Expense Budget

Production Budget

Expense Budgets Marketing Administrative

Raw Material
Purchases and Usage

Direct Labour Factory Overhead
the entire plan of operations are reflected in

Financial Plans Supporting Budgets Budgeted Balance Sheet Profit & Loss
Cash (cash Flows) Capital Budgets

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(c) Operational Budgeting
Budgeting Illustrative Example
The United Aerospace Company is preparing its operating budget schedules for 2005. The budget director, together with the budget committee has gathered the following information: Projected Sales 2005: Product Widgets Gadgets Unit Sales 75,000 44,000 Unit Sell Price $30 $40

Schedule of Finished Goods Inventories: Product Widgets Gadgets Bill of Materials for each product The following table outlines raw material requirements for the production of a single unit : Amount Used Raw Material A B C Schedule of Raw Material Inventories: Raw Material Expected Purchase price $1.00 /kg. $0.80 /Kg. $1.20 /units Opening Inventories 1st Jan, 2005 32,000 kg 29,000 kg 6,000 units Desired Ending Inventories 31st Dec, 2005 36,000 kg 32,000 kg 7,000 units Unit kg. Kg. units Widget 4 2 0 per unit Gadget 5 3 1 Actual 1/1/2005 20,000 8,000 Desired 31/12/2005 25,000 14,000

A B C

Projected Direct Labour requirements for 2005 and expected rates are as follows:

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Product Widgets Gadgets Overhead application rates are set at: Variable Overhead Fixed Overhead

Hours per unit 1.5 2

Rate per hour $8 $8

$3 per direct labour hour $1 per direct labour hour

The FIXED overhead application rate was calculated based on total budgeted fixed overhead of $220,000 for the year with Normal Capacity being set at 220,000 direct labour hours per annum. Marketing and administrative expenses are estimated to be: Variable Component Fixed Component 5% of Sales Revenue $80,000 per annum.

It is proposed to build budget schedules using the above information. The order in which the budget schedules are prepared is important and should logically be prepared using the following sequence: 1. 2. Sales Budget Production Budget (a) Raw Materials Budget (b) Direct Labour Budget (c) Overhead Applied Budget. Unit Cost Schedule Cost of Goods Manufactured Budget. Cost of Goods Sold Budget. Expense Budget. Budgeted Income Statement.

3. 4. 5. 6. 7.

The solution to the illustrative example, in the order of completion is presented below:

1.

Sales Budget

The first step in budgeting is the determination of the sales budget. This sets the level of anticipated activity upon which production, inventory levels, and expenses are planned. The preparation of the sales budget depends on the estimation of the following information : • the sales forecast in units, • the selling price or pricing policy of the firm.

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Responsibility for this budget usually belongs to the chief marketing executive of the firm who relies on inputs from market research groups and the sales force.

SALES BUDGET Unit Sales Unit Selling Price Total Sales

Widgets

Gadgets

Total

2.

Production Budget

Once the sales budget has been determined, the production budget can be prepared. Assuming the firm maintains finished goods inventory, the desired ending inventory can be compared with periodical sales estimates to determine periodical production. The production budget is usually prepared in the following format:

Production = Sales Units + Closing Inventory Units - Opening Inventory Units
The preparation of the production budget depends on : (i) (ii) the sales forecast in units (provided by sales budget) the inventory objectives or inventory policy of the firm. PRODUCTION BUDGET Sales Add Closing Inventory Widgets Gadgets

Less Opening Inventory Production

(a)

Raw Materials Budgets

Once the production budget is determined, the material usage and purchases budget can be prepared. On the basis of the estimated production and the number of units of material required to produce one unit of finished product, the number of units of material needed for production is determined. Assuming the firm has a material inventory policy, the desired ending material inventory can be compared with the production estimates to determine material purchases.

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The preparation of the material usage and purchases budget rests on the estimation of the following information : (i) (ii) (iii) (iv) Production (as provided by production budget). The material requirements (bill of materials) for each unit of finished product. The expected purchase price per unit of material. The raw material inventory policy of the firm.

MATERIALS USAGE BUDGET Widgets A

A

B

C

Gadgets

A

TOTAL REQUIREMENTS

MATERIALS PURCHASES BUDGET TOTAL REQUIRMENTS (USAGE ) Add Inventory 31 Dec, 2005 Total Requirements Less Inventory 1 Jan, 2005 PURCHASES QUANTITY Unit Price PURCHASES AMOUNT $ Total Purchases : Material A Material B Material C Projected Purchases

A

B

C

(b)

Direct Labour Budget

Once the production budget has been determined, the direct labour budget can also be prepared. The total hours needed for production is determined on the basis of the estimated production and the number of direct labour hours required to produce one unit of finished product. The total direct labour costs expected are based on a knowledge of the labour rates and production times required for the manufacture of each type of product. The direct labour budget is based on an estimation of :

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(i) (ii) (iii)

Production (as provided by the production budget). The current labour rates in force. Direct labour time allowances for the production of each type of product.

LABOUR BUDGET Production Hours per unit Total Hours Hourly rate Projected Labour Cost

Widgets

Gadgets

Total

(c)

Overhead Applied Budget

Variable manufacturing overhead costs vary with units produced. Fixed manufacturing overhead gives a firm the capacity to produce. Once the production level is known, the overhead budget can be prepared, as it depends on the anticipated activity level and upon the behaviour of the individual cost items in relation to the level of activity. (Refer to previous topics on Cost Behaviour patterns and Flexible Budgets for more detail). The overhead budget can be set at an expected activity level includes both variable and fixed costs. Its preparation depends upon an estimation of : (i) (ii) Production activity level (measured by units or direct labour hours etc. as provided by the production budget). The cost behaviour patterns of individual overhead cost items.

OVERHEAD BUDGET Direct Labour Hours Variable Overhead Rate Variable Overhead Applied Fixed Overhead Rate Fixed Overhead Applied TOTAL OVERHEAD APPLIED

Widgets

Gadgets

Total

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3.

UNIT COST BUDGETS

Expected unit costs or "standard costs" provide the building blocks for the budgeting system.

Widgets Direct Materials A B C Total Materials Direct Labour Applied Overhead Variable Overhead Fixed Overhead Total Cost per Widget

Gadgets

4.

COST OF GOODS MANUFACTURED BUDGET.

The cost of goods manufactured budget provides total cost information about the firm's projected production requirements. It is usually a static budget.

Widgets Direct Materials A B C Total Materials Direct Labour Applied Overhead Total Manufacturing Costs

Gadgets

Total

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5.

COST OF GOODS SOLD BUDGET.

The cost of goods sold budget shows the monetary magnitude of movements in the firm's finished goods inventory. It highlights, actual or projected opening inventories to which is added the current cost of production of finished goods and to derive the cost of goods sold amount, projected costs associated with closing inventories is deducted.

Widgets Opening Inventory Widgets Gadgets Production

Gadgets

Total

Closing Inventory Widgets Gadgets COST OF GOODS SOLD

6.

EXPENSE BUDGET.

Expenses are made up of a number of cost items some of which may be classified as fixed and some variable. The variable expenses are dependant upon sales volume and thus vary directly with sales. The preparation of marketing and administrative expense budgets depends upon an estimation of : (i) (ii) Sales (as provided by the sales budget). The cost behaviour pattern of individual expense items.

Marketing & Admin Expenses Variable Expenses

Widgets

Gadgets

Total

Fixed Expenses Total Expenses

7.

BUDGETED INCOME STATEMENT.

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The budgeted income statement may be prepared after all the previously mentioned budgets have been made available (that is, sales, production, materials, labour, overhead, cost of goods sold and expense budgets). The budgeted income statement is the final budget of all the operational budgets. Widgets Sales Less Cost of Goods Sold Gross Profit Less Marketing & Admin Expenses Net Income Gadgets Total

(d)

Incentives for Accurate Forecasts

The most important forecast in the budgeting process is the sales figure as the entire budget process is framed around it. • • If the sales forecast is too high, for example, and the company produces to meet the forecast, the company will have excess inventory. If the sales forecast is too low, the firm will likely lose sales opportunities because purchasing and production were planning on lower operating levels.

Rewarding managers only for accurate forecasting could create disincentives for better performance managers would try merely to meet the forecast, not to beat it. The above discussion focused only on sales. However, the principles applicable to sales forecasting should be applied to all areas of a firm's operations that utilise budgets to guide operation as well as enable performance evaluation.

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Summary & Conclusions
This topic looked at the operating budget, which managers use for planning, control, and employee motivation. After management makes decisions about products to produce, pricing, levels of output, production techniques, and so forth, accountants translate the choices into a formal plan of action, known as the master budget profit plan. The most important forecast is that critical factor that most constrains the firm. Because the marketplace constrains most firms, the sales forecast is usually the place to start. Both sales personnel and market research staff usually provide input for sales forecasts. The budgeted production volume is a function of the sales forecast and desired beginning and ending inventory levels of finished goods. From the production budget estimates of : • • • materials purchases and usage can be made labour requirements and cost forecasts can be made, overhead forecasts are made.

Accountants estimate production costs using engineering studies, blueprints, and product specifications. The cost per unit of input is based on projected materials prices and labor wage rates. Whereas direct materials and direct labor costs are often engineered, that is, traceable directly to a unit of finished product, manufacturing overhead costs are not. Estimates of marketing and administrative costs complete the profit plan. The profit plan is only one part of the master budget, which also includes the cash budget and budgeted balance sheet. The master budget profit plan is fixed; that is, it is based on the budgeted sales volume. The flexible budget is based on the actual sales volume, however. Whereas the fixed budget shows budgeted costs at the projected sales volume, the flexible budget shows budgeted costs at the actual sales volume.

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Lecture Demonstration Problem:
1. The Grove Company manufactures two products, Gadgets and Widgets. The budget department generated the following data in order to project sales and production requirements for the year ending 30th June, 2005: Product Gadgets Widgets Projected Unit Sales 6,000 4,000 Projected Sell Price $60.00 $90.00 Opening Stock 2,000 800 Closing Stock 2,500 900

Material requirements for the production of completed units are as follows: Raw Material Filler Steel Carton Unit of Measurement Kg Kg Each Gadget 3 2 0 Widget 4 3 1

Projected data in relation to raw material requirements for 2005 are as follows: Raw Material Filler Steel Carton Unit Cost $7 $4 $3 Opening Stock 3,200 Kg 2,900 Kg 600 Closing Stock 3,600 Kg 3,200 Kg 700

Projected direct labour requirements for 2005 and rates are as follows: Product Gadgets Widgets Hours Per Unit 3 2 Rate per Hour $4.00 $5.00

Overhead is applied at the rate of $3.00 per direct labour hour. REQUIRED (a) Prepare a production budget in units for each product. (b) Prepare a raw materials purchases and usage budget in both Units and Dollars. (c) Calculate the manufacturing cost per unit for both Widgets and Gadgets. (d) Prepare a budgeted manufacturing statement for each product and in total for the coming year. .

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Homework Exercises:
Question 1: In producing their product, No-Go Electronics uses two XCL-70 silicon chips which they buy from an outside supplier for $3 per chip. No-Go's marketing department forecasts that the following unit sales will occur during the first quarter of the year. Forecast Unit Sales 15,000 12,000 18,000

Month January February March

Sales are expected to be 63,000 units in the second quarter of the year. For planning purposes, second quarter sales are forecast to be the same each month (that is 21,000 units in each of the months, April, May and June). Company policy is to carry an inventory of finished units at the end of a month equal to two-thirds of the forecasted unit sales for the following month. Because of a close relationship between No-Go management and its suppliers the company only needs to maintain raw materials inventory at the end of a month equal to 5% of the next month's planned usage. Required. (a) Prepare a production budget by month for January, February and March of 2005. (opening stock of Finished Goods as at January 1, 2005 is 10,000 units) (b) Prepare a Materials Usage and Purchases budget in units and dollars for January, February and March, 2005 (opening stock of XCL-70 as at 1st January 2005, is 1,300 units).

Question 2: Expected sales of product Alpha are as follows: July $6,000 August $7,200 September $9,000 October $8,100

Closing Stock at the end of each month is equal to 10% of the expected sales for the following month. Required: Prepare a production budget for the months of July, August and September.

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Question 3: MCA Industries has prepared the following forecast of sales and production of its best selling product, Widgets : July Anticipated Sales (Units) 80,000 100,000 90,000 120,000 August Sept. October

Opening Stock of Widgets as at 1st July 2005 was 16,000 units. Physical quantities of Closing Stock of Widgets at the end of each month is equal to 20 per cent of next months expected sales. The production specifications for the manufacture of a widget is as follows : Materials Silk 4 metres @ $10.00 per metre Wood 2 metres @ $5.00 per metre Labour 2 hours at $15.00 per hour Overhead is applied at 66.67% of Direct Labour Cost. Raw Materials inventories as at 1st July are: Silk 33,600 Wood 16,800 the company wants to maintain closing inventories of raw materials equal to 10 per cent of the following month's production requirements. Required : For the months of JULY and AUGUST prepare : (a) (b) Production Budget in Units. Raw Material USAGE and PURCHASES budget for Silk and Wood in both PHYSICAL quantities and DOLLAR amounts. Direct Labour Budget in Hours and dollar amounts. Unit Cost Schedule Cost of Goods Manufactured Budget clearly showing: Income Statement.

(c) (d) (e) (f)

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Question 4: The Grove Company manufactures two products, Gadgets and Widgets. The budget department generated the following data in order to project sales and production requirements for the year ending 30th June: Product Gadgets Widgets Projected Unit Sales 5,000 7,000 Projected Sell Price $70.00 $90.00 Opening Stock 1,000 1,000 Closing Stock 2,000 2,000

Material requirements for the production of completed units are as follows: Raw Material Filler Steel Carton Unit of Measurement Kg Kg Each Gadget 2 3 1 Widget 3 4 1

Projected data in relation to raw material requirements for the year are as follows: Raw Material Filler Steel Carton Unit Cost $6 $5 $2 Opening Stock 3,000 Kg 2,000 Kg 1,500 Closing Stock 4,000 Kg 3,000 Kg 1,000

Projected direct labour requirements for the year and rates are as follows: Product Gadgets Widgets Hours Per Unit 3 4 Rate per Hour $7.00 $7.00

Overhead is applied at the rate of $6.00 per direct labour hour. Selling and Administrative expenses amount to $15,000 per month plus a variable component of 3% of sales. Required : (a) (b) (c) (d) (e) Prepare a production budget in units for each product. Prepare a raw materials purchases and usage budget in both Units and Dollars. Calculate the manufacturing cost per unit for both Widgets and Gadgets. Prepare a budgeted manufacturing statement for each product and in total for the coming year. Prepare a budgeted Income Statement for the Period.

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Question 5:
The budget department for Ashant Productions has gathered the following data concerning future sales and production requirements: Anticipated Sales for 2006: Product A B C Expected inventories of finished goods are as follows: Product A B C Opening Inventory 1st January 2006 8,000 15,000 6,000 Closing Inventory 31st December 2006 10,000 15,000 6,000 Unit Sales 20,000 50,000 30,000 Sell Price $120 $150 $160

The bill of materials for the manufacture of each product and expected purchase price is as follows: Amount used per unit Stock No. 210 150 410 330 220 Unit Price $4.00 each $3.00 each $3.50 / kilo $5.00 / kilo $3.50 /metre Unit Each Each Kilograms Kilograms Metres A 3 2 B 1 2 3 C 5 3

5

4

Expected inventories of raw materials are as follows : Stock No. 210 510 410 330 220 Opening Inventory 1st January 2006 21,000 units 17,000 units 10,000 kilos 18,000 kilos 25,000 metres Closing Inventory 31st December 2006 25,000 units 23,000 units 15,000 kilos 18,000 kilos 30,000 metres

Labour requirements and rates per direct labour hour are: Product A B C Overhead is applied at a flat rate of $8.00 per hour. Required: 1. Production budget (in units). 2. Direct materials usage and purchase budget in units and dollars. 3. Direct labour budget in hours and dollars. 4. The cost per completed unit for each product. 5. The dollar value of Finished Goods inventory as at 31st December 2006. Hours per unit 4 5 5 Rate per hour $8.00 $12.00 $10.00


				
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