Budgeting
State why organisations produce budgets
Answer
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To motivate managers by giving them goals
To co-ordinate business activities
To help foresee potential problems
To formalise business plans and objectives
To have a basis on which to make comparisons with actual results
Budgeting
1: Wrong Ltd had originally set out its master budget for 2013 based on
an expected volume of 100000 units as follows (sales and production
were planned to be 100000 units).
Sales
Cost of Sales
Direct Materials
300,000
Direct labour
200,000
Variable
production 100,000
overheads
Fixed costs
Budgeted profit
1,000,000
600,000
400,000
200,000
200,000
At the end of 2013, however, it was revealed that Wrong Ltd had
understated its volume of output by 50% when compared to the actual
volume.
You are required to prepare a flexible budget, which the management of
Wrong Ltd can use to evaluate the actual performance of the enterprise in
the area of cost control.
1
Answer
Sales
Cost of Sales
Direct Materials
Direct labour
Variable
production
overheads
Fixed costs
Budgeted profit
2: Orion Ltd plans to sell 50000 units in the forthcoming year. The selling
price is estimated at $30 per unit. The unit cost comprises the following
Direct Costs
 Direct Materials
 Direct labour
 Direct Expenses
1 unit at $2.50
4 hours at $2.00 per hour per unit = $8
$3 per unit
Indirect Costs
 Administration Costs $220,000
 Distribution Costs
$60,000
 Marketing Costs
$300,000
Taxation is 30% of pre-tax profits.
There is no interest payable or receivable.
Design an incremental budget for Orion Ltd.
2
‘Variance Analysis
A key word to understand when you are looking at budgets is “variance”
A variance arises when there is a difference between actual and budget
figures
Variances can be either:


Positive/favourable (better than expected) or
Adverse/unfavourable ( worse than expected)
A favourable variance might mean that:


Costs were lower than expected in the budget, or
Revenue/profits were higher than expected
By contrast, an adverse variance might arise because:


Costs were higher than expected
Revenue/profits were lower than expected
Should variances be a matter of concern to management? After all, a
budget is just an estimate of what is going to happen rather than reality.
The answer is – it depends.
The significance of a variance will depend on factors such as:
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Whether it is positive or negative – adverse variances (negative)
should be of more concern
Was it foreseen?
Was it foreseeable?
How big was the variance - absolute size (in money terms) and
relative size (in percentage terms)?
The cause
Whether it is a temporary problem or the result of a long term trend
“Management by exception” is the name given to the process of
focusing on activities that require attention and ignoring those that appear
to be running smoothly
Budget control and analysis of variances facilitates management by
exception since it highlights areas of business performance, which are not
in line with expectations.
3
Items of income or spending that show no or small variances require no
action. Instead concentrate on items showing a large adverse variance.
Are all adverse variances bad news?
Here is a point that students often find hard to understand – or believe!
An adverse variance might result from something that is good that has
happened in the business.
For example, a budget statement might show higher production costs than
budget (adverse variance). However, these may have occurred because
sales are significantly higher than budget (favourable budget).
Remember, it is the cause and significance of a variance that matters
– not whether it is favourable or adverse.
Variances illustrated
Consider the following budget statement:
Item
Sales
Revenue
Standard
Product
Premium
Product
Total Sales
revenue
Costs
Wages
Rent
Marketing
Other
overheads
Total Costs
Profit
Budget
Actual
75
90
30
25
105
115
35
15
20
27
38
17
14
35
97
8
104
11
Variance
4
What do the numbers in the budget statement tell us?
Looking at the sales revenue section, you can see that actual sales of
standard product were £15k higher than budget – this is a positive
(favourable) variance.
Turning to the costs section, actual wages were £3k higher than budget –
i.e. an adverse (negative) variance.
Overall, the profit variance was positive (favourable) – i.e. better than
budget.’
Source: http://www.tutor2u.net/business/accounts/variance-analysis.html
[accessed Sunday 22nd March, 2015]
5
Flexible Budgeting
1: Bracken dale Ltd
When the standards for the year ahead were set, it was expected that
monthly output of units manufactured would be 10,000 units. By the time
July was reached, output had fallen to 8000 units per month because of a
fall in market sales.
The original budget is based on the following information:
(a) Direct Material Cost = $4 per kg of raw materials
(b) Direct labour Cost = $5 per hour
(c) Variable Cost rate of $3 per direct labour hour.
(d) Fixed Overhead is $7000
(e) Each unit of output requires 0.5 kg of raw materials and 12
minutes of labour time.
The actual cost of direct materials was found to be $4.40 per kg.
The actual cost of direct labour was found to be $5.50 per hour.
The actual variable overhead cost rate was $2.80 per direct labour hour.
Fixed Overhead was actually $7500
3800 kg of materials were used and the actual labour hours worked were
2000
Complete the following table
Units Manufactured
Original Budget
Actual for July
10,000
8000
Direct Material
Direct Labour
Variable Overhead
Fixed Overhead
Total Direct Costs
6
Now what if a flexible budget had been constructed earlier? This budget
foresaw that output would be 8000 in July. Now calculate the figures for
the flexible budget. You must use the original information to compute
the figures
Direct Material Cost = $4 per kg of raw materials
Direct labour Cost = $5 per hour
Variable Cost rate of $3 per direct labour hour
Fixed overhead is $7000
Each unit of output requires 0.5 kg of raw materials and 12
minutes of labour time.
Flexible Budget
Units Manufactured
8000
Direct Material
Direct Labour
Variable Overhead
Fixed Overhead
Total Direct Costs
Now calculate the flexible budget variances
Original
Budget
(1)
Flexible
Budget
(2)
Actual for
July
(3)
Variance
(2) – (3)
Units Manufactured
Direct Material
Direct Labour
Variable Overhead
Fixed Overhead
Total Direct Costs
7
2: G Ltd produces and sells a single product. The budget for the latest
period is as follows:
Sales revenue (12600)
Variable Costs
Direct materials
Direct labour
Production overhead
Fixed Costs
Production overhead
Other overhead
Budgeted Profit
277200
75600
50400
12600
(138600)
13450
10220
(23670)
114930
The actual results for the period were as follows:
Sales revenue (13200)
303600
Variable Costs
Direct materials
78350
Direct labour
51700
Production overhead
14160
(144210)
Fixed Costs
Production overhead
13710
Other overhead
10160
(23870)
Budgeted Profit
135520
Prepare a flexible budget control statement and comment on the results
8
Answer
Flexed/Flexible Budget
Sales revenue (13200)
Variable Costs
Direct materials
Direct labour
Production overhead
Fixed Costs
Production overhead
Other overhead
Budgeted Profit
9
Flexible Budget Control Statement for the latest period
Activity
Sales
Revenue
Original
Budget
12600
277200
Variable
Costs
Direct
75600
material
Direct
50400
Labour
Production 12600
overhead
Flexed
Budget
13200
Actual
Results
13200
Variance
303600
78350
51700
14160
Fixed costs
Production 13450
overhead
13710
Other
10220
overhead
Total Costs 162270
10160
Profit
135520
114930
168080
10
3: The Arcadian Hotel operates a budgeting system and budgets
expenditure over eight budget centres as shown below. Analysis of past
expenditure patterns indicates that variable costs in some budget centres
vary according to occupied room night (ORN), while in others the
variable proportion of costs varies according to the number of visitors
(V).
The budgeted expenditures for a period with 2000 ORN and 4300 V were
as follows:
Budget centre
Variable
vary with
Cleaning
Laundry
Reception
Maintenance
Housekeeping
Administration
Catering
General
overheads
ORN
V
ORN
ORN
V
ORN
V
----
costs Budgeted
expenditure
13250
15025
13100
11100
19600
7700
21460
11250
Budget
expenditure
includes
$2.50 per ORN
$1.75 per V
$12100 fixed
$0.80 per ORN
$11000 fixed
$0.20 per ORN
$2.20 per V
All fixed
112485
. In period 9, with 1850 ORN and 4575V, actual expenditures were as
follows:
Budget Centre
Cleaning
Laundry
Reception
Maintenance
Housekeeping
Administration
Catering
General overheads
Actual Expenditure
13292
14574
13855
10462
19580
7930
23053
11325
114071
(a) Determine the flexible budget cost allowance for period 9
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(b) What is the total budget allowance for the flexible budget, and
calculate the total expenditure variance for period 9.
Answer
Activity Variable Variable Fixed
cost per cost
cost
unit($)
allowance allowance
($)
Cleaning
1850
Laundry
4575
Reception
1850
Maintenance 1850
Housekeeping 4575
General
--overheads
Total
budget
cost
allowance
4: Green Day PLC manufactures a component for the motor industry. The
following flexible budgets have already been prepared for 50%, 60% and
75% of the plant’s capacity
Output levels
75%
Units
50%
60%
5000
6000
7500
Direct Materials
Direct Wages
Production Overheads
Other overhead costs
Admin Expenses
$
55000
35000
45000
14000
20000
$
66000
42000
45000
14000
20000
$
82500
52500
45000
14000
20000
169000
187000
214000
Profit is budgeted to be 25% of sales
(a) Classify the above costs into fixed and variable costs. Give reasons
for your choice
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(b) Calculate the cost per unit for direct materials and direct wages
(c) Prepare a flexible budget for 90%
5: Martone PLC manufactures components for the electrical industry. The
following flexible budgets have already been prepared for 60%, 70% and
80% of the plant’s capacity.
Output levels
Units
60%
12000
70%
14000
80%
16000
Direct Materials
Direct Wages
Production overheads1
Other overheads2
Admin Expenses
$
84000
48000
60000
50000
30000
$
98000
56000
66000
58000
30000
$
112000
64000
72000
66000
30000
272000
308000
344000
Profit is budgeted at 20% of sales
(a) Separate production overheads and other overheads into fixed and
variable elements
(b) Prepare a flexible budget for a 90% activity level
1
2
Production Overheads has a fixed and variable component
Other overheads has a fixed and variable component
13