MANAGEMENT ACCOUNTING PRINCIPLES
Third year
Second term
Lecture (2) & (3)
Chapter (2):
Budgeting for planning and control
Learning objectives
After studying this chapter, you should be able to:
1. Define budgeting and discuss its role in planning, controlling,
and decision making.
2. Prepare the operating budget, identify its major components,
and explain the interrelationships of the various components.
3. Identify the components of the financial budget, and prepare a
cash budget.
4. Describe budgets for merchandising and service firms.
The budget—For planning and control
A budget is a tool that managers use to plan and control the use
of scarce resources. Time and money are scarce resources to all
individuals and organizations; the efficient and effective use of
these resources requires planning. Planning alone, however, is
insufficient. Control is also necessary to ensure that plans actually
are carried out.
Most budgets are prepared for a one-year period. The yearly
budget can be broken down into quarterly and monthly budgets.
This chapter explains the master budget, which consists of a
planned operating budget and a financial budget. The planned
operating budgets help to plan future earnings and results in a
budgeted income statement. The financial budgets help
management plan the financing of assets and results in a
budgeted balance sheet.
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Building the Master Budget
The master budget is a comprehensive financial plan made up of
various individual departmental and activity budgets for the
year. A master budget can be divided into:
(1) Operating budgets, which outline the income-generating
activities of a company (sales, production, and manufacturing
costs). The operating budget focuses on the day-to-day
running of the company and it usually covers a one-year
period.
The outcome of the operating budgets is a pro forma
(budgeted) income statement.
(2) Financial budgets, which outline the inflows and outflows of
cash and the financial position.
The outcome of the financial budgets includes a Cash budget
and Capital budgets are a pro forma (budgeted) balance
sheet.
The master budget is usually prepared for a one-year period
corresponding to the company’s fiscal year. The yearly master
budget can be broken down into quarterly and monthly budgets to
allow managers to compare actual data with budgeted data and to
make timely corrections.
Operating Budgets
The operating budgets include the budgets for sales, production,
manufacturing costs (materials, labor, and overhead) or
merchandise purchases, selling expenses, and general and
administrative expenses.
1. Sales budget
The cornerstone of the budgeting process is the sales budget
because the usefulness of the entire operating budget depends
on it. The sales budget involves estimating or forecasting how
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MANAGEMENT ACCOUNTING PRINCIPLES
Third year
Second term
much demand exists for a company's goods and then determining
if a realistic, attainable profit can be achieved based on this
demand. Sales forecasting can involve either formal or informal
techniques, or both.
Formal sales forecasting techniques often involve the use of
statistical tools. For example, to predict sales for the coming
period, management may use economic indicators (or variables)
such as the gross national product or gross national personal
income, and other variables such as population growth, per capita
income, new construction, and population migration.
To use economic indicators to forecast sales, a relationship must
exist between the indicators (called independent variables) and
the sales that are being forecast (called the dependent variable).
Then management can use statistical techniques to predict sales
based on the economic indicators.
Management often supplements formal techniques with informal
sales forecasting techniques such as intuition or judgment. In
some instances, management modifies sales projections using
formal techniques based on other changes in the environment.
Examples include the effect on sales of any changes in the
expected level of advertising expenditures, the entry of new
competitors, and/or the addition or elimination of products or
sales territories. In other instances, companies do not use any
formal techniques. Instead, sales managers and salespersons
estimate how much they can sell. Managers then add up the
estimates to arrive at total estimated sales for the period.
Usually, the sales manager is responsible for the sales budget and
prepares it in units and then in dollars by multiplying the units by
their selling price. Although its components are simple, the two
items needed to prepare the budget, is often difficult and time‐
consuming.
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The sales budget in units is the basis of the remaining budgets
that support the operating budget.
Sales = Units × Selling price per unit
Example (1):
The Pickup Trucks Company, which makes toy trucks, has just
completed its budgeting process for next year. Total expected
sales are 100,000 toy trucks at a price of $15.00 each. The
expected sales are as follows:
Q1: 15,000,
Q2: 17,000,
Q3: 28,000,
Q4: 40,000 units
Required:
Prepare the sales budget on a quarterly basis.
Solution:
Pickup Trucks Company
Sales Budget for the year ended December 31, 2025
Total
Units sold
Quarter 1 Quarter 2 Quarter 3 Quarter
4
15,000
17,000
28,000
40,000
Selling price
$ 15
Total
sales
$ 15
target $ 225,000 255,000
100,000
$ 15
$ 15
$ 15
420,000
600,000
1,500,000
Note:
In addition to annual and quarterly sales budgets, monthly
budgets are often prepared so sales can be tracked against
expectations more frequently than once every three months.
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MANAGEMENT ACCOUNTING PRINCIPLES
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2. Production budget
Before preparing the direct materials, direct labor, and
manufacturing overhead budgets, the production budget must be
completed.
The production budget shows the number of units that must be
produced. To budget for annual production, three things must be
known: the number of units to be sold (the units in the sales
budget), the required level of inventory at the end of the year,
and the number of units, if any, in the beginning inventory (the
company's inventory policy). If quarterly budgets are required,
this same information is needed on a quarterly basis.
Units to be produced =
Ending inventory units + Target units sold – Beginning
inventory units
Example (2):
Furniture, Inc., estimates the following number of mattress sales
for the first four months of 2025:
Month
Sales
January
10,000 units
February
14,000
March
13,000
April
16,000
Finished goods inventory at the end of December is 3,000 units.
Target ending finished goods inventory is 30% of the next month's
sales.
Required:
How many mattresses need to be produced in the first
quarter (January, February, March) of 2025?
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MANAGEMENT ACCOUNTING PRINCIPLES
Third year
Second term
Solution:
Furniture, Inc. Company
Production Budget for the first quarter of 2025
January
February
March
Expected units
sold
+
Required
ending Inventory
Beginning
Inventory
Units
to
be
produced
10,000
14,000
13,000
Total
37,000
14,000*30%= 13,000*30%= 16,000*30%= 4,800
4,200
3,900
4,800
(3,000)
(4,200)
(3,900)
(3,000)
11,200
13,700
13,900
38,800
3. Manufacturing costs Budgets
Manufacturing costs budgets compose of direct materials, direct
labor, and manufacturing overhead budgets.
3.a. Direct materials budget (Purchases budget):
The direct materials budget determines the number of units of
raw materials to be purchased. It uses the number of units to be
produced from the production budget, the required level of
ending inventory for raw materials, and the number of units in
beginning inventory. Once the number of units to be purchased is
determined, it is multiplied by the cost per unit to determine the
budgeted amount for raw materials purchases.
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Second term
Units to be produced (production Budget)
xx
x Direct materials needed per unit of each finished goods xx
= Total Direct material units needed for production
xx
+ Desired ending inventory of direct materials
xx
− Beginning Direct materials on hand
(xx)
= Direct materials needed to be purchased
xx
x Cost per Direct materials unit (Unit price)
xx
= Direct Material Purchases costs (cost of purchases)
xx
Example (3):
Alex. Company provides the following data for next year:
Month
Direct Material needed for production
January
72,000 Kg.
February
64,800
March
79,200
April
86,400
Inventory at the end of December is 21,600 Kg. and target ending
inventory levels are 30% of next month's direct material needed
for production. The cost per direct material unit is $10.
Required:
Prepare the direct materials budget (Purchases budget) in the
first quarter (January, February, March) of 2025.
Solution:
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MANAGEMENT ACCOUNTING PRINCIPLES
Third year
Second term
Alex. Company
Direct Material Budget for the first quarter of 2025
January
February
March
Total
DM
Units
production
needed
for 72,000
64,800
79,200
216,000
+
Desired
Inventory
ending
DM 64,800*30%
=
19,440
91,440
79,200*30%
=
23,760
88,560
86,400*30%
=
25,920
105,120
25,920
(-) Beginning Direct Material (21,600)
Inventory
(19,440)
(23,760)
(21,600)
Direct Material purchase 69,840
needed for production
69,120
81,360
220,320
* Unit price
10
10
10
691,200
813,600
2,203,200
purchases required
Direct
costs
Material
10
purchase 698,400
Example (4):
Alex. Company wants 25,000 units to be produced during March.
At Alex. Company, five pounds of material are required per unit of
product.
Management wants materials on hand at the end of each month
equal to 10% of the following month’s production needs.
Expected production units in April are 28,000 units.
On March 1, 13,000 pounds of material are on hand. Material
cost is $0.70 per pound.
Required:
Prepare the direct materials budget for March.
Solution:
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241,920
MANAGEMENT ACCOUNTING PRINCIPLES
Third year
Second term
Alex. Company
Direct materials Budget for the month ended March 31, 2025
March
Units to be produced (production Budget)
25,000
x Direct materials needed per unit of each finished goods
5 pounds
= DM Units needed for production (25,000 * 5)
125,000
+ Desired ending DM inventory (28,000 *5) * 10%
14,000
(-) Beginning DM Inventory
(13,000)
= Direct materials needed to be purchased
126,000
x Cost per Direct materials unit (Unit price)
0.7
= Direct Materials Purchase costs
$ 88,200
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MANAGEMENT ACCOUNTING PRINCIPLES
Third year
Second term
Lecture (4)
Budgeting for planning and control:
Manufacturing costs Budgets
3.b. Direct labour budget
The direct labor (DL) budget shows the total direct labor hours
needed and the associated cost based on the input-output
relationship of each product.
Expected DL hours = DL hours needed per unit of output × Units
of output
DL costs = Expected DL hours × Wage rate
Example (5):
Alex. Manufacturing Inc. produces two products, A and B. Alex
expects to sell 10,000 units of product (B) and to have an
inventory of 2,000 units of (B) on hand at the end of the period.
Currently, Alex has 800 units of (B) on hand. Product (B) requires
two labor operations, molding and polishing. Each unit of product
(B) requires one hour of molding and two hours of polishing.
The direct labor rate for molding is $20 per molding hour and the
direct labor rate for polishing is $25 per polishing hour.
Required:
Prepare the direct labour budget for product (B).
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MANAGEMENT ACCOUNTING PRINCIPLES
Third year
Second term
Solution:
Alex. Company
Production budget for product (B)
Product (B)
Sales
10,000 units
+ Required ending Inventory
2,000
Units required
12,000
- Beginning Inventory
(800)
Units to be produced
11,200 units
Direct labour budget for product (B)
Product (B)
Units to be produced
11,200 units
Labour operations
Molding
Polishing
Direct labour hour per unit
1
2 hours
Expected Direct labour hours
(11,200*1=)
11,200
$ 20
(11,200*2=)
22,400
$ 25
* direct labour rate
The expected cost of direct labour 224,000
$ 560,000
for operation
Total expected cost of direct labour
$ 784,000
for (B)
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Second term
3.c. Overhead budget
The overhead budget shows the expected cost of all indirect
manufacturing items.
The estimated overhead is divided into variable and fixed
components:
Total overhead cost = Variable overhead cost + total fixed overhead
costs
In more details:
Total overhead = (Variable overhead rate × Activity level per chosen
cost driver) +
Budgeted total fixed overhead
costs
Example (6):
Alex. Manufacturing Inc. expects to produce and sell 6,000 units
of product (A), its only product, for $20 each. Variable
manufacturing overhead is $3 per unit. Fixed manufacturing
overhead is $24,000 in total.
Required:
Prepare the overhead budget for product (A).
Solution:
Alex. Manufacturing Inc.
Overhead budget for product (A)
Product (A)
Units to be produced
6,000 units
* Variable manufacturing overhead per
$3
unit
= Variable manufacturing overhead
(6,000 * 3 =) 18,000
+ Fixed manufacturing overhead
$ 24,000
= Total overhead costs
42,000
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MANAGEMENT ACCOUNTING PRINCIPLES
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Second term
4. Selling, administrative, and other expense budgets
To prepare the Master Budget you need to prepare operating
budgets and financial budget. You had studied Purchases, Direct
Labour, and Manufacturing Costs Budgets as operating budgets.
As well, Selling, Administrative, and other expense budgets are
parts of operating budgets.
The costs of selling a product are closely related to the sales
forecast. Generally, the higher the forecast, the higher the selling
expenses.
Administrative expenses are likely to be less dependent on the
sales forecast because many of the items are fixed costs (e.g.
salaries of administrative personnel and depreciation of
administrative buildings and office equipment).
Managers must also estimate other expenses such as interest
expense, income tax expense, and research and development
expenses.
Example (7):
Alex. Manufacturing Inc. expects to produce and sell 6,000 units
of product (A), its only product, for $20 each.
Variable selling and administrative expenses are $1 per unit, and
fixed selling and administrative costs are $3,000 in total.
Required:
Prepare the selling and administrative Budget.
Solution:
Alex. Manufacturing Inc.
Selling and Administrative Budget
Product (A)
Units to be produced
6,000 units
Variable selling and administrative expenses
6,000 * 1 =
Fixed selling and administrative costs
$ 3,000
Total selling and administrative costs
9,000
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6,000
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Second term
5. Budgeted Income Statement
A budgeted income statement is simply a predicted income
statement for a future period of time.
The budgeted income statement is an important part of a
business's financial planning process. The budgeted income
statement, along with a budgeted balance sheet, can help a
business determine if its plans are financially feasible. A business
can develop and compare different budget projections to help in
making decisions about which projects the business should
pursue and how it can pay for them.
Example (8):
Alex. Company projects sales of 25,000 units during May at $6 per
unit. Production costs are $1.80 per unit. Variable selling and
administrative expenses are $0.60 per unit; fixed selling and
administrative expenses are $60,000.
Required:
Prepare the budgeted Income Statement before income
taxes.
Solution:
Alex. Company
Budgeted Income Statement
Sales units
25,000 units
X Selling price per unit
$6
= Sales revenue
$150,000
(-) Cost of goods sold
25,000 units * $1.8
(45,000)
Gross Margin
105,000
(-) Variable selling and administrative 25,000 units * $0.60
expenses
(-) Fixed selling and administrative
costs
Net income before taxes
(15,000)
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(60,000)
$ 30,000
MANAGEMENT ACCOUNTING PRINCIPLES
Third year
Second term
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