Advanced cost of accounting Chapter 5 2024.doc

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CHAPTER FIVE
Budget and Budgetary Control
Learning Objectives:
To familiarize you with:
 The basic aspects of financial planning and the role of budgeting.
 The various types of budgets & the preparation of a master budget.
 Some new ideas and developments in the area of budgeting.
Introduction
For you, reviewing the past information alone is not enough since your job involves not
only predicting but also shaping the future of your enterprise. This requires proper
planning about the activities of the business. Finance being the life blood of business,
financial planning is of utmost significance to a businessman. A budget is an important
tool for financial planning and control.
Financial Planning
Financial planning is concerned with raising of funds and their effective utilization with
a view to maximize the wealth of the company. It includes the determination of:
 The amount of funds needed for implementing various budget plans.
 The pattern of financing, i.e., the forms and proportions of various corporate
securities, such as shares, debentures, bonds, bank loans to be issued or raised.
 The timing of the sales (floatation) of securities.
In spite of a good financial plan, the desired results may not be achieved if there is no
effective control to ensure its implementation. The budgets represent a set of yardsticks/
benchmarks or guidelines for use in controlling internal operations of an organization. The
management, through budgets, can evaluate the performance of every level of the
organization. The discrepancy between plan performance and actual performance is
highlighted through budgets. The organization may have to change the course of its
operations in a particular area or revise its plans keeping in view the changing conditions.
What is a budget?
A budget is a plan expressed in quantitative, usually monetary terms, covering a
specified period of time, usually one year. In other words, a budget is a systematic plan
for the utilization of manpower and material resources. In a business organization a
budget represents an estimate of future costs and revenues. Budgets may be divided into
two basic classes: Capital budgets, and Operating budgets.

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Capital budgets are directed towards proposed expenditures for new projects and often
require special financing. The operating budgets are directed towards achieving short term
operating goals of the organization, for instance, production or profit goals in a business
firm. Operating budgets may be sub-divided into various departmental or financial budgets.
The main characteristics of a budget are:
a. It is prepared in advance and is derived from the long term strategy of the
organization.
b. It relates to future period for which objectives or goals have already been laid down.
c. It is expressed in quantitative form, physical or monetary units, or both.
A budget helps us in the following ways:
1. It brings about efficiency and improvement in the working of the organization.
2. It is a way of communicating the plans to various units of the organization. By
establishing the divisional, departmental, sectional budgets, exact responsibilities
are designed. It thus minimizes the possibilities of back-passing, if the budget
figures are not met.
3. It is a way of motivating managers to achieve the goals set for the units.
4. It serves as a benchmark for controlling ongoing operations.
5. It helps in developing a team spirit where participation in budgeting is
encountered.
6. It helps in reducing wastages and losses by revealing them in time for corrective
action.
7. It serves as a basis for evaluating the performance of managers.
8. It serves as a means of educating managers.
Budgetary Control
No system of planning can be successful without having an effective and efficient system of
control. The exercise of control in the organization with the help of budgets is known as
“budgetary control”.
The process of budgetary control includes:
i. Preparation of various budgets
ii. Continuous comparison of actual performance with budgetary performance.
iii. Revision of budgets in the light of changed circumstances.
A system of budgetary control should not become rigid. There should be enough scope for
flexibility to provide individual initiatives and derive. Budgetary control is an important
device for making the organization more efficient on all fronts. It is an important tool for
controlling costs and achieving the overall objectives.
Objectives of Budgetary Control
Budgetary control is essential for policy planning and control. It also acts as an instrument
of coordination. The main objectives of budgetary control are as follows:

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1. To ensure planning for future by setting up various budgets. The requirements and
expected performance of the enterprise are anticipated.
2. To coordinate the activities of different departments.
3. To coordinate various cost centers and departments with efficiency and economy.
4. Elimination of waste and increase in profitability.
5. To anticipate capital expenditure for future.
6. To centralize the control system.
7. Fixation of responsibility of various individuals in the organization.
Characteristics of Good Budgeting
1. A good budget system should involve persons at different levels while preparing the
budget. The subordinates should not feel any imposition on them.
2. There should be a proper fixation of authority and responsibility. The delegation of
authority should be done in a proper way.
3. The targets of the budgets should be realistic, if the targets are difficult to be
achieved then they will not enthuse the persons concerned.
4. A good system of accounting is also essential to make the budgeting successful.
5. The budgeting system should have a whole-hearted support of the top management.
6. The employees should be imparted budgeting education. There should be meetings
and discussions and the targets should be explained to the employees concerned.
7. A proper reporting system should be introduced, the actual results should be
promptly reported so that performance appraisal is undertaken.
Installing a Budgetary Control System
Having understood the meaning and significance of budgetary control in an organization, it
will be useful to you to know how a budgetary control system can be installed in the
organization. This requires, first of all, finding answers to the following questions in the
context of an organization:
1. What is likely to happen?
2. What can be made to happen?
3. What are the objectives to be achieved?
4. What are the constraints and to what extent their effects can be minimized?
Having found answers to the above questions, the following steps may be taken for
installing an effective system of budgetary control in an organization.
I. Organization for Budgeting
The setting of a definite plan of organization is the first step towards installing budgetary
control system in an organization. A budget manual should be prepared giving details of

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the powers, duties, responsibilities and areas of operation of each executive in the
organization.
Organization Chart for budgetary control
II.Responsibility for budgeting
The responsibility for preparation and implementation of the budgets may be fixed as
under:
a. Budget Officer/ Controller: Although the chief executive is finally responsible
form the budget program, it is better if a large part of the supervisory
responsibility is delegated to an official designated as a Budget officer or
Budget controller. Such a person should have knowledge of the technical
details of the business and should report directly to the Chief executive or the
General manager of the organization.
b. Budget Committee: The Budget Officer is assisted in his work by the budget
Committee. The committee may consist of Heads of Various departments, Viz.,
production, sales, finance, human resource, etc. with the Budget Officer its
chairman. It is generally the responsibility of the Budget Officer to submit,
discuss, and finally approve the budget figures. Each head of the department
Chief
executive/
General
manger
Production
Manager
i. Production
budget
ii. .plant
Utilization
Marking
Manager
i. Sales
budget
ii. Advertise
ments cost
budget
Finance Manager
i. Receipts budget
ii. .Payments Budget
Accounts
Manager
Cost budget
Budget
Officer
Budget
Committee
R & D
Manager
D&D Budget
HR Manager
Labor budget

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should have his own sub-committee with executives working under him as its
members.
c. Fixation of the Budget Period: Budget period means the period for which a
budget is prepared and employed. The budget period depends upon the nature
of the business and the control techniques.
d. Budget Procedures: Having established the budget organization and fixed the
budget period, the actual work or budgetary control can be taken upon the
following patterns:
i. Key factor: It is also termed as Budget Limiting factor. The extent of the
influence of this factor must first be assessed in order to ensure that the budget
targets are met. It would be desirable to prepare first the budget relating to this
particular factor, and then prepare the other budgets. The key factor should be
correctly identified.
ii. Making a forecast: A forecast is an estimate of the future financial conditions
or operating results. Any estimate is based upon consideration of probabilities. An
estimate differs from a budget in that the latter embodies an operating plan of an
organization. A budget envisages a commitment to certain objectives or targets
which the management seeks to attain on the basis of the forecasts prepared. A
forecast may be prepared in financial or physical terms for sales, production,
costs, or other resources acquired for business. Instead of just one forecast a
number of alternative forecasts may be considered with a view to attaining the
most realistic overall plan.
iii. Preparing budgets: After the forecasts have been finished the
preparation of budgets follows. The budget activity starts with the preparation of
the sales budget. Then production budget is prepared on the basis of the sales
budget and the production capability available. Financial budgets (like Cash or
Working Capital) will be prepared on the basis of sales forecasts and production
budget. All these budgets are combined and coordinated into a Master Budget.
The budgets may be revised in the course of the financial period if it becomes
necessary to do so in view of the unexpected developments which have already
taken place or are likely to take place.
Limitations of Budgetary Control
Despite many good points of budgetary control there are some limitations of this system.
Some of the limitations are discussed below:
1. Uncertain future. The budgets are prepared for the future period. Despite best
estimates made for the future, the prediction may not always come true. The future
uncertainties reduce the utility of budgetary control system.

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2. Budgetary Revisions Required. Budgets are prepared on the assumptions that
certain conditions will prevail. Because of future uncertainties, assumed conditions
may not prevail necessitating the revision of budgetary targets.
3. Discourages Efficient Persons. Under budgetary control system the targets are
given to every person in the organization. The common tendency of people is to
achieve the targets only. There may be some efficient persons who can exceed the
targets but they will not feel contented by reaching the targets. So budgeting may
serve as constraints on managerial initiatives.
4. Problem of Coordination. The success fo budgetary control depends upon the
coordination among different departments. The performance of one department
affects the results of other departments. To overcome the problem of coordination a
Budgetary Officer is needed. Every concern can not afford to appoint a Budgetary
Officer. The lack of coordination among different departments results in poor
performance.
5. Conflict among Different Departments. Budgetary control may lead to conflicts
among functional departments. Every departmental head worries for his department
goals without thinking of business goal. Every department tries to get maximum
allocations of funds and this raises a conflict among different departments.
6. Depends upon Support of Top Management. Budgetary control system depends
upon the support of top management. The management should be enthusiastic for
the success of this system and should give full support for it. If at any time there is a
lack of support from top management then this system will collapse.
Classification and Types of Budgets
The budgets are usually classified according to their nature. The following are the types of
budgets which are commonly used:
A. According to time
1. Long term budgets (5 to 10 years)
2. Short term budgets (1 to 2 years)
3. Current budgets (monthly or weekly)
B. On the basis of function
1. Operating budgets
i. Sales budget
ii. Production budget
iii. Production cost budgets
iv. Plant utilization budget
v. Selling & Administrative budgets
vi. Program budgets

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vii. Responsibility budgets
2. Financial budgets
i. Cash budget
ii. Working capital budget
iii. Capital expenditure budget
iv. Budgeted income Statement
v. Budgeted balance Sheet
3. Master budget
C. On the basis of flexibility
i. Fixed budget (given level of activity)
ii. Flexible budget (consists of series of budgets for different levels of activity)
Let us discuss some of the budgets covered in the above classification:
Sales budget
Sales budget generally forms the fundamental basis on which all other budgets are built.
The budget is based on projected sales to be archived in a budget period. The sales
manager is directly responsible for the preparation and execution of this budget. He usually
takes into consideration the following organizational and environmental factors while
preparing the sales budget:
Organizational factors:
 Past sales figures and trends
 Salesmen’s estimates
 Plant capacity
 Orders on hand
 Proposed expansion or discontinuation of products
 Availability of materials or supplies
 Financial aspect
 Cost of distribution of goods
Environmental factors:
 General trade prospects
 Seasonal fluctuations
 Financial markets
 Degree of competition
 Government controls, rules and regulations related to the industry
 Political situation and its impact on the market.
It is desirable to break up the entire sales budget on the basis of different products, time
period and sales areas or territories.

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Production budget
This budget provides an estimate of the total volume of production distributed product wise
with the scheduling of operations by days, weeks, and months, and a forecast of the
inventory of finished products. Generally, the production budget is based on the sales
budget. The responsibility for the overall production budget lies with the technical manager
and that is production manager.
Production budget may be expressed in physical or financial terms or both in relative to
production. The production budget attempts to answer questions like:
1. What is to be produced?
2. When it is to be produced?
3. How it is to be produced?
4. Where is to be produced?
The production budget serves as a basis for preparation of related cost budgets, e.g.,
material cost budget, labor cost budget, etc. it also facilitates the production of cash
budget. The production budget is prepared after taking into consideration several factors
like:
 Inventory policies
 Sales requirements
 Production stability
 Plant capacity
 Availability of materials and labor
 Time taken in production process.
Production Cost budget
Basically, there are three elements of cost, namely direct material, direct labor, and factory
overhead. Separate budgets for each of these elements have to be prepared.
Direct material budget
The direct material budget has two components:
1. Materials requirement budget, and
2. Materials procurement or purchase budget.
The former deals with the total quantity of materials required during the budget period,
while the latter deals with the materials to be acquired from the market during the budget
period. Materials to be acquired are estimated after taking into account the closing and
opening inventories and the materials for which orders have already been placed.
Direct Labor Budget
Direct labor budget like direct material budget, may be divided into two categories:
1. Direct labor requirement budget, and

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2. Direct labor procurement or purchase budget.
The former deals with the total direct labor requirement in terms of quantity and value;
while the latter states the additional direst workers to be recruited.
Overheads Cost Budget
The overhead costs may relate to manufacturing, general & administrative, and selling
& distribution functions. Separate budgets may, therefore, be prepared for Manufacturing
Overhead, General & Administrative Overhead, and Selling & Distribution Overheads.
The Manufacturing Overheads cost is that part of work cost which arises from indirect
labor, indirect materials, overheads and other factory expenses, manufacturing cost is
excluded from direct material and direct labor. Manufacturing overhead cost may be
classified into fixed cost, variable cost and semi-variable cost.
The General & Administrative Overheads cost includes all expenses relating to general
and administration on the enterprise. The fixed expenses under this category may be
estimated on the bases of past experience and anticipated changes. . Variable general and
administration overheads will vary with the anticipated sales figures.
The Selling & Distribution Overheads Cost includes all expenses relating to selling,
advertising and distribution of goods. The fixed expenses under this category may be
estimated on the bases of past experience and anticipated changes. Variable selling and
distribution overheads will vary with the anticipated sales figures.
Cash Budget
A cash budget is a summary of the firm’s expected cash inflows and outflows over a
particular period of time. In other words, cash budget involves a projection of future cash
receipts and cash disbursements over various time intervals.
A cash budget helps the management in:
 Determining the future cash needs of the firm
 Planning the financing of those needs, and
 Exercising control over cash and liquidity of the firm.
The overall objective of cash budget is to enable the firm to meet all its commitments in
time and at the same time to prevent accumulation at any time unnecessary large cash
balances with it.
Illustration of Master budget for Non-Manufacturing Company
Components of Master budget

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The terms used to describe assorted budget schedules vary from organization to
organization, however, most Master budgets have common elements. The usual Master
budget for a non-manufacturing company has the following components.
A. Operating budget
1. Sales budget (and other cost driver budgets as necessary)
2. Purchase budget
3. Cost of goods sold budget
4. Operating expenses budget
5. Budgeted income statement
B. Financial budget
1. Capital budget
2. Cash budget
C. Budgeted balance sheet
he two major parts of a Master budget are the operating budget and the financial budget. The
operating budget focuses on the income statement and its supporting schedules, though
sometimes called the profit plan. An operating budget may show a budgeted loss, or even by
used to budget expenses in an organization or agency with no sales revenues. In contrast, the
financial budget focuses on the effects that the operating budget and other plans (such as
capital budgets and repayments of debt) will have on cash.
Basic Steps in Preparation of Master Budget for Merchandising Enterprise:-
The principal steps in preparing the Master budget are
Operating budget
1. using the data, given, prepare the following defiled schedules for each of the months of the
planning horizon.
a. Sales budget
b. Cash collection form customers
c. Purchase budget
d. Disbursements for purchases
f. Disbursements for operating expenses

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2. using these schedules, prepare a budgeted income statement financial budget
3. Using the data given and the supporting schedules, prepare the following forecasted
financial statements.
A. cash budget including details of borrowings, repayments, and interest for each month
of the planning horizon
B. Budgeted balance sheet as of the end period
You will need schedules 1a, 1c, and 1e to prepare the budgeted income statement and
schedules 1b, 1d and 1f to prepare the cash budget.
Organizations with effective budget systems have specific guidelines for the steps and timing
of budget preparation. Although the details differ, the guidelines invariably include the
preceding steps.
Step 1. Preparation of operation budget
You should now be ready to trace the budgeting process.
Step 1a. Sales budget
The sales budget is the starting point for budgeting because inventory levels, purchases and
operating expenses are geared to the rate of sales activities.
Step 1b. Cash collections
It is easiest to prepare schedule b, cash collections, at the same time as preparing the sales
budget. Cash collections include the current month’s cash sales plus the previous month’s
credit sales. We will use total collections in preparing the cash budget.
Step 1c. Purchases budget
After sales are budgeted, prepare the purchase budget (schedule c). The total merchandise
needed will be the sum of the desired ending inventory plus the amount needed to fulfill
budgeted sales demand. The total need will be partially met by the beginning inventory; the
remainder must come from planned purchases.
The purchases are computed as follows:-
Budgeted purchases = desired ending inventory and cost of goods sold less beginning
inventory
Step 1d. Disbursements for purchases

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Scheduled, disbursements for purchase, is based on the purchase budget. Disbursements
include if 50% of the current month’s purchases and if 50% of the previous month’s
purchases. No will use total disbursements in preparing the cash budget
Step 1.e operating expense budget
The budgeting of operating expenses depends on various factors. Month-to-month
fluctuations in sales volume and other cost drive activity directly influence many operating
expenses. Example of expenses driven by sales volume include sales commissions and many
delivery activities [such as rent, insurance, depreciation, and salaries] with appropriate
relevant rages and are regarded as fixed.
Trace the total operating expenses in the final column of schedule, which summarizes these
expenses, to the budgeted income statement.
Step1 f operating expenses disbursements
Disbursements for operating expenses are based on the operating expense budget.
Disbursements include 50% of last month’s and this month’s wages and commissions, and
miscellaneous and rent expenses. We will use the total of these disbursements in preparing
the cash budget.
Step 2: preparation of budgeted income statement
Step1a through if provide enough information to construct a budgeted income statement
from operations. The income statement will be complete after addition of the interest expense,
which is computed after the cash budget, has been prepared. Budgeted income from
operations is often a benchmark for judging management performance.
Step3: Preparation of financial budget
The second major part of the Master budget is the financial budget, which consists of the
capital budget, cash budget, and ending balance sheet.
Step 3a- Cash Budget

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The cash budget is a statement of planned cash receipts and disbursements. The cash budget
is heavily affected by the level of operations summarized in the budgeted income statement.
The total cash available before financing equals the beginning cash balance plus cash receipts.
Cash receipts depends on collections from customers’ accounts receivable and cash sales and
n their operating income sources.
Cash disbursement for
1. Purchases depend on the credit terms expended by suppliers and the bill paying habits
of the buyer
2. Payroll depends on wage, salary and commission terms and on payroll dates.
3. Some costs and expenses depend on contractual terms for installment payments,
mortgage payments, rents, leases and miscellaneous items.
4. other disbursements include outlays for fixed assets, long term investments, dividends
and the like
Management determines the minimum cash balance desired depending on the nature of the
business and credit arrangements.
Financing requirements depend on how the total cash available compares with the total cash
needed. Needs include the disbursements plus the desired ending cash balance. If the total
cash available is less than the cash needed, borrowing is necessary to cover the planned
deficiency. If there is an excess, loans may be repaid. The pertinent outlays for interest
expenses are usually contained in this section of the cash budget.
Cash budgets help management to avoid having unnecessary idle cash, on the one hand, and
unnecessary cash deficiencies, on the other. A well-managed financing program keeps cash
balances from becoming too large or too small.
Step 3b Budgeted Balance Sheet
The final step in preparing the Master budget is to construct the budgeted balance sheet that
projects each balance sheet item in accordance with the business plan as expressed in the
previous schedules.

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When the complete Master budget is formulated, management can consider all the major
financial statements as a basis for changing the course of events:
Illustration
To illustrate the budgeting process, we will use as an example the ABC company as follows: -
Given data
1. The budgeted period: - July-Sep. 202x (for 3 months)
2. The actual balance sheet, June 30th, 202x is shown below
ABC Company
Balance sheet
June 30th, 202x
ASSETS LIABILITY & CAPITAL
Cash 20,000 Account payable 16,000
A/R 12,000 Wages payable 3,000
Inventory 16,000 Commission payable 600
Prepaid insur. 10,000 Owners equity 54,400
Equipment 30,000
Accn. Deprecation (14,000) ____
Total 74,000 74,000
2. All sales are made 60% on account and 40% on cash. The credit sales are entirely collected
following the month of sales
3. Purchases are made 60% on account and 40% on cash, The credit purchases are paid in
following month the amount of purchase
4. Payments for wages and commission are made 70% in the month and 30% in the following
month
5. Money can be borrowed at 9% interest, borrowing is made at the begun and repayments
are end of months on FIFO based in multiples of Birr 2000.00.

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6. Cost of goods sold is estimated at 65% of sales and ending inventory of Birr 40,000.00 is
desired at the end of any month.
7. Minimum cash balance of birr 20,000.00 is required at the end of any month.
8. The organization has a plan to purchase a new equipment in the first half of August for
birr 10,000 that will be used expenditure to acquired fixed asset
9. Cost equipment and insurance expire at a rate of 20% on book value per month
10.Salesmen commission are estimated to be 10% of sales
11.Forecast for wages and sales are as follows:
July August September
Sales 20,000 100,000 18,000
Wages 6,000 4000 4000
Required:-
Prepare a Master budget for three months ending Sep. 202x.
Solution
ABC Company
Master Budget
For 3 Months Ending Sep30, 202X
1A. Sales budget July Aug. Sep. Remark
Cash sales, 40% 8000 40,000 7,200
Plus credit sales, 60% 12,000 60,000 10,800
Total sales, 100% 20,000 100,000 18,000 138,000
1B. Collection from sales
Cash sales 40% 8000 40000 7200
Plus collection of A/R, 60% 12000 12000 60000
Total 20000 52000 67200
1C. Purchases budget
C.G.S (65% of sales) 13000 65000 11700 89700
Plus desired ending inventory 40000 40000 40000

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Available for sales 53000 105000 51700
Less beginning inventory 16000 40000 40000
Purchased 37000 65000 11700
1D. disbursements for purchase July Aug Sep. Remark
Cash purchase, 40% 14800 26000 4680
Plus payment of A/P, 60% 16000 22200 39000
Total 30800 48200 43680
1.E operating expense budget
Wages 6000 4000 4000
Sales commission (10% of sales) 2000 10000 1800
Insurance (20%) 2000 1600 1280
Depreciation (20%) 3200 4560 3648
Total 13200 20160 10728 44088
1.F Disbursements and operating
Operating expenses
For this month
Wages (70%) 4200 2800 2800
Commission (70%) 1400 7000 1260
For last month
Wages (30%) 3000 1800 1200
Commission (30%) 600 600 3000
Total 9200 12200 8260

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2. BUDGETED INCOME STATEMENT
ABC COMPANY
FOR CASTLED INCOME STATEMENT
3 MONTHS ENDING SEP 30, 202X
Sales data source of data
Sales 138,000 1A
Less cost of goods sold 89,700 1C
Gross margin 48,300
Less Operating expenses 44,088 1E
Income from operation 4,212
3A. Cash budget ABC Company cash budget for 3 months ending Sep 30, 202X
July Aug. Sep. Remark
Beginning cash balance 20000 20000 21600
Add. Cash collection 20000 52000 67200
Total cash available
before financing(W) 40000 72000 88800
Less cash disbursements
Purchase 30800 48200 43680
Expense 9200 12200 8260
Equipment __--____ 10000 _---__
Total cash disbursements (X) 40000 70400 51940
Add minimum cash
balance desired (Y) 20000 20000 20000
Total cash needed 60000 90400 71940
Excess (deficiency) of total cash
Available over total cash needed
Before financing (W-X-Y) (20000) (18400) 16860
Financing
Borrowing (at beginning
of month) 20000 20000 -----_
Repayment of debt (at end
of month) ---- ---- (16000)
Interest (at 9% per year) ---- ---- (360.00)
Total cash increase (decrease)
From financing (Z) 20000 20000 (16360)
Ending cash balance ((W-X) +Z) 20000 21600 20500

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Additional
1. interest on the principal paid September 202X
Interest = Principal x Rate x Time
16,000 x 9/100 x 3/12 = 360.00
2. loans outstanding September 202X
1st Loan = 20,000 – 16,000 = 4,000
2nd Loan 20,000
Total 24,000
3. Interest accrued on loans outstanding
4000 x 9/100 x 3/12 = 90.00
20,000 x 9/100 x 2/12 = 300.00
Total 390.00
4. Total interest expense (paid and un paid)
360+390 = 750.00
Forecasted capital statement
Beginning capital June 201X ---- ---------------------------54,400
Operating income statement ------4212.00
Less:- Interest (360+390) 750.00
Net increase in capital 3462.00
Ending capital, September 202X 57,862.00

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3. B Budgeted balance sheet
ABC Company
Budgeted balance sheet
September 30, 202X
Current Assets Current liabilities
Cash 20,500 Account payable 7020
Account receivable 10,800 Wage payable 1200
Inventory 40000 Commission payable 540
Insurance 5120 Loans Payable 24000
Equipment 40000 Interest payable 390
(30,000+10,000) Owners’ Equity 57862
Acc. Dep. (25,408) (54,400+3462)
(14,000+11,408) _________ _____
Total Assets 91,012 Total Lib. & Capital 91,012
Choice between Fixed and Flexible Budgets
A budget may be fixed or flexible. A fixed budget is based on a fixed volume of activity. It
may lose its effectiveness in planning and controlling if the actual capacity utilization is
different from what was planned for any particular unit of time, e.g., a month or a quarter.
The flexible budget is more useful for changing levels of activity as it considers fixed and
variable costs separately. If flexible budgeting approach is adapted, the Budget Officer can
analyze the variance between actual costs and budgeted costs depending upon the actual
levels of activity attained during a period of time.
Development of a Flexible Budget
A budget that is based on a prior prediction of expected sales and production is
called a Static Budget. Budgets may also be drawn up for series of possible
production after the fact.
These budgets, based on Cost-Volume-Profit or Cost-Volume relationships are
called Flexible Budgets, and are used to determine what costs should have been for

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an attained volume of activity. Before preparing a flexible budget, management must
understand “how costs respond to changes in changes in volume of output.
The flexible budget cost estimating equation for total monthly/yearly production
costs is illustrated as follows:
Fixed Costs Variable Costs
Direct material $10x
Direct labor $ 6x
Factory overhead $50,000 $ 4x
Total Cost $50,000 $20x
Where “x” equals the number of units produced. If management planned to produce
10,000 units in July, 2016, the budgeted manufacturing costs for July would be
$250,000.
Manufacturing Costs
Direct material (10,000 x $10) $100,000
Direct labor (10,000 x $6) $ 60,000
Variable – FOH (10,000 x $4) $ 40,000
Fixed – FOH $ 50,000
$250,000
If the actual July production happens to equal 10,000 units, the performance report
for the production Department should be based on a comparison of actual and
budgeted manufacturing costs.
But, if production units is other than that specified in the manufacturing budget,
such as a 11,000 units, it would be inappropriate to compare actual and budgeted
manufacturing costs – fixed costs should be same at all levels of production, variable
costs will fluctuate.
In this case, for the purpose of performance evaluation, a flexible budget is tailored,
after the fact, to the actual level of activity.
Actual Data: 11,000 units were produced and related cost data:
Direct material $108,000 @9.81
Direct labor $ 70,000 @6.32
Variable – FOH $ 44,000 @4.00
Fixed – FOH $ 51,000
Flexible Budget & Performance Evaluation

21
Based on Static Budget
Actual Budget Variance
Volume 11,000 10,000 1,000
Particulars:
Direct material $108,000 $100,000 $ 8,000
Direct labor 70,000 60,000 10,000
Variable FOH 44,000 40,000 4,000
Fixed FOH 51,000 50,000 1,000
Production costs $273,000 $250,000 $23,000
Based on Flexible Budget
Volume 11,000 11,000 -
Particulars:
Direct material $108,000 $110,000 $ 2,000 Favorable
Direct labor 70,000 66,000 4,000 Unfavorable
Variable FOH 44,000 44,000 -
Fixed FOH 51,000 50,000 1,000 Unfavorable
Production costs $273,000 $270,000 $3,000 Unfavorable
Thus, personnel should be evaluated on the basis of flexible budgets drawn up for
the actual level of production to be willing to respond to changes.
Assume for the above example, the sales budget for July, 2016 called for the sale of
10,000 units at $40 each. If the firm actually sold 11,000 units at $39 each, the
total Revenue Variance would be $29,000.
Actual Sales (11,000 x $39) $429,000
Budgeted Sales (10,000 x $40) $400,000
Total Sales Variance $ 29,000 Favorable
Note: (I) Selling price declined from $40 to $39
(II) Sales volume increased from 10,000 to 11,000 units.
These two causes of total variance are identified as the sales price variance and
the sales volume variance.

22
The Sales Price Variance (SPV): indicates the impact of revenues on changes in
selling prices, given the actual sales volume.
Computation:
Actual minus Budgeted times Actual
SPV = Sales Price sales Price Sales Volume
The Sales Volume Variance (SVV): indicates the impact of revenues of the
change in sales volume, assuming there was no change in selling price.
Computation:
Actual minus Budgeted times Actual
SVV = Sales Volume sales Volume Sales Price
Thus,
Sales Price Variance= ($39 - $40) x 11,000 units = $11,000 Unfavorable
Sales Volume Variance= (11,000 – 10,000) x $40 = $40,000 Favorable
Total Sales Variance = $29,000 Favorable
Sales Budget (For Evaluation Sale Department)
Assume the Sales Department calls for Fixed costs of $10,000 and Variable costs of
$5 per unit sold. If the actual fixed and variable selling expenses for July are $9,500
and $65,000 respectively.
The total cost variances assigned to the Sates Department are $9,500
(Unfavorable).
Volume 11,000 11,000 -
Selling Expenses:
Variable $66,000 $55,000 $10,000 Unfavorable
Fixed 9,500 10,000 500 Favorable
Total $66,000 $55,000 $ 9,500 Unfavorable
Exercise:
The costs and expenses for the production of 5,000 units in a factory are given as
follows:
Per unit
Direct material $ 50
Direct labor 20
Variable FOH 15

23
Fixed FOH ($50,000) 10
Administrative Expenses (5% variable) 10
Selling Expenses (20% fixed) 6
Distribution Expenses (10% fixed) 5
Total cost of sales per unit $116
Required:
You are required to prepare a budget for the production of 7,000 units.
Solution
5,000 Units 7,000 Units
Particulars Per unit Amount Per unit Amount
Direct material $50.00 250,000 $50.00 350,000
Direct labor 20.00 100,000 20.00 140,000
Prime Costs 70.00 350.000 70.00 490,000
Factory Overheads:
Variable FOH 15.00 75,000 15.00 105,000
Fixed FOH ($50,000) 10.00 50,000 7.14 50,000
Production costs 95.00 475,000 92.14 645,000
Operating Expenses:
Administrative Expenses (5% variable) 0.50 2,500 0.50 3,500
Administrative Expenses (95% fixed) 9.50 47,500 6.79 47,500
Selling Expenses (80% variable) 4.80 24,000 4.80 33,600
Selling Expenses (20% fixed) 1.20 6,000 0.86 6,000
Distribution Expenses (90% variable) 4.50 22,500 4.50 31,500
Distribution Expenses (10%fixxed) 0.50 2,500 0.36 2,500
Total cost of sale 116.00 580,000 109.95 769,600
Master Budget
Illustration of Master Budget for Manufacturing Company
The master or final budget is a summary budget which incorporates the various functional
budgets. It is prepared by integrating various budgets into one consolidated budget.

24
The master budget is prepared by the budget officer and requires the approval of the
Budget Committee before it is put into operations. The budget may take the form of
Projected Income Statement and a balance sheet at the end of the budget period.
Demonstrative Problem:
A Glass Manufacturing Company expects from you to calculate and present the master
budget for the year 202X from the following information.
Sales:
Toughened Glass $300,000
Bent Toughened Glass $500,000
Production costs:
Direct material cost: 6% of sales
Direct wages: 20 workers @ $150 per month
Factory overheads:
Indirect labor: Plant manager $500 per month and Foreman $400 per month.
Stores and Spares: 2.5% on sales
Depreciation on machinery: $12,500
Light and power: $5,000
Repairs and maintenance: $8,000
Other sundry expenses: 10% of direct wages
Administrative, Selling and Distribution expenses $14,000 per year.
Required:
You are required to prepare a Master Budget for Year-Ending 202X.
Solution
Glass Manufacturing Company
Master budget
For year Ending 202X

25
I. Sales Budget:
Toughened Glass $300,000
Bent Toughened Glass $500,000
$800,000
II. Production Cost Budget:
Direct materials, 60% of sales $480,000
Direct wages (20 workers x $150 x 12 months) 36,000
Prime costs $516,000
Factory Overheads:
Variable Overheads:
Stores & Spares 2.5% on sales $20,000
Light & Power 5,000
Repairs & maintenance 8,000 33,000
$549,000
Fixed Overheads:
Plant manager ($500 x 12 months) $ 6,000
Foreman ($400 x 12 months) 4,800
Depreciation 12,600
Other Sundry Expenses (10% x $36,000 Wages) 3,600 27,000
$576,000
III. Gross Profit: (I minus II) $224,000
IV. Administrative, Selling, & Distributive expenses 14,000
V. Expected Net Profit $210,000
===ENDS===

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