Week 11

The Budgetary Process and Types of Budgets

Lecture Example 1

Preparing operating budgets

A company manufactures two products, Aye and Bee. Standard cost data for the
products for next year are as follows:
Product Aye Product Bee
per unit per unit
Direct materials:
X at £2 per kg 24kg 30kg
Y at £5 per kg 10kg 8kg
Z at £6 per kg 5kg 10kg
Direct wages:
Unskilled at £6 per hour 10 hrs 5 hrs
Skilled at £8 per hour 6 hrs 5 hrs

Budgeted inventories for next year are as follows:

Product Aye Product Bee
units units
1 January 400 800
31 December 500 1,100

Material X Material Y Material Z

kg kg kg
1 January 30,000 25,000 12,000
31 December 35,000 27,000 12,500

Budgeted sales for next year: Product Aye 2,400 units. Product Bee 3,200 units.

Prepare the following budgets for next year:

(a) production budget, in units;

(b) material purchases budget, in kg and by value;
(a) direct labour budget, in hours and by value.

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Sales are our limiting factor
(a) Production budget
Aye Bee
(units) (units)
Sales
Closing Inventory
Opening Inventory
Production

(b) Materials
Usage X Y Z
Product Aye
Product Bee
Usage
Closing Inventory
Opening Inventory
Purchases
@ £2/£5/£6

c) Labour budget
Unskille
d Skilled Total
(hours) (hours)
Product Aye
Product Bee

@ £6 / £8

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Lecture Example 2

Activity Based Budgeting

The traditional approach to budgeting presents costs in a manner which

emphasises their nature. Thus, the traditionally arranged budget for a local
authority public cleansing department over a given period might appear as:

Item of cost £
Wages 140,000
Materials 28,000
Vehicle hire 35,000
Equipment hire 18,000
Total 221,000

The weakness of this approach is that it gives little indication of the link between
the level of activity of the department and the costs incurred. The budget might
be restated as an activity-based budget as follows:

Activity £ Number of activities

Street sweeping 84,000 4,000
School cleaning 68,000 800
Park cleaning 39,000 130
Graffiti removal 30,000 150
221,000

This approach provides a clear framework for understanding the link between
costs and the level of activity. If you can identify appropriate ‘cost drivers’ then a
very high proportion of costs reveal themselves to be variable.

Of course, ABBs and traditional budgets are not mutually exclusive. The two can
be prepared in parallel or they can be integrated.

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Lecture Example 3

Fixed and flexible budgets

A company manufactures a single product and the following data show the actual
results for the month of April compared with the budgeted figures.

Operating statement for April

Actual Budget Variance
Units produced and sold 1,000 1,200 (200)
£ £ £
Sales revenue 110,000 120,000 (10,000)

Direct material 16,490 19,200 2,710

Direct labour 12,380 13,200 820
Production overhead 24,120 24,000 (120)
Administration overhead 21,600 21,000 (600)
Selling and distribution o/head 16,200 16,400 200
Total cost 90,790 93,800 3,010
Profit 19,210 26,200 (6,990)

Looking at the costs incurred in April, a cost saving of £3,010 has been made
compared with the budget. However the number of units produced and sold was
200 less than budget, so some savings in expenditure might be expected. It is
not possible to tell from this comparison how much of the saving is due to
efficient cost control, and how much is the result of the reduction in activity.

Management have identified that the following budgeted costs are fixed.
£
Direct labour 8,400
Production overhead 18,000
Administration overhead 21,000
Selling and distribution overhead 14,000

Required

Prepare a more appropriate budgetary statement

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 Flexed Budget (1,000 units)
Fixed Variable Total Actual Variance
£ £/unit £ £ £
Sales revenue
Direct material
Direct labour
Prod O/H
Admin O/H
S&D O/H
Total cost
Profit

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 Tutorial / Workshop Questions

Griffithstown Generators Co. manufactures three different products, P, Q and R,

each of which requires two key materials, A and B. The sales manager has
stated that although he can estimate the likely sales volume for each product with
reasonable accuracy for a three month period, this never seems to be reflected in
the production plan.

He has provided the following estimates for the next three months:

Estimated sales volumes (units)

Product P Q R
September 4,000 3,100 2,400
October 4,400 3,500 2,100
November 4,600 3,900 2,700

Production is driven by the availability of raw materials, as the company buys

materials in order to benefit from any fall in prices. This means that at times there
will be a surplus of one material and a shortage of another.

The material requirements for each product are:

Product P Q R

Material:
A (kg) 8 11 15
B (kg) 6 9 11

The production manager stated that he feels the company should maintain an
inventory of raw material at the end of each month which is sufficient for 20% of
the production requirement for the next month. The sales manager indicated that
if the plans were properly coordinated, the finished goods inventory could be held
at a constant rate for each product as follows:

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Finished goods inventory (units)

Product P Q R
1,000 500 1,800

It is estimated that at the end of August, the inventory levels will be:

Raw materials A 2,400 kg

B 4,800 kg

Finished goods P 400 units

Q 2,900 units
R 800 units.

Griffithstown Generators Co. has been facing increasing competition in the

market place. As a consequence there have been issues concerning the
availability and costs of the specialised materials and employees needed to
manufacture the products, and there is concern that these might cause problems
in the current budget setting process, which is fundamentally a form of
incremental budgeting.

Required:

(a) Prepare monthly budgets for September and October for:

(i) Production volume for each product;

(ii) Material usage volume for each material and;

(iii) Material purchase volume for each material.

(b) Explain how Zero Based Budgeting could overcome the problems that
might be faced as a result of the continued use of the current system.

(c) Critically evaluate the role of rolling budgets and whether they would be
suitable for a company like Griffithstown Generators Co.

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2

HIP Co. (HC) is a precision engineering company that manufactures titanium

replacement joints for use in joint replacement operations. There are a number
of different departments in the company including design, general production and
precision finishing.

HIP Co prepared its budget for the year ending 31 December 2011 using an
incremental budgeting system. The budget is set centrally and is then
communicated to each of the managers who have responsibility for achieving
their respective targets.

The following report has been produced for the precision finishing department for
June 2011:
Budget Actual Variance
Number of machine hours 10,000 13,470 3,470 (F)
£ £ £
Consumable materials 104,800 148,000 43,200 (A)
Cleaning materials 12,500 14,200 1,700 (A)
Other direct materials 4,700 5,970 1,270 (A)
Direct labour 135,000 172,500 37,500 (A)
Production overheads 92,300 127,600 35,300 (A)
_______ _______ ______
Total 349,300 468,270 118,970 (A)
_______ _______ ______

The Manager of the precision finishing department has received a memo from
the Financial Controller requiring him to explain the serious overspending within
his department.

The Manager has sought your help and, after some discussion, you have
ascertained the following information:

 The cleaning materials, consumable materials and other direct materials

vary in proportion to the number of machine hours.
 The budgeted direct labour costs include fixed salary costs of £32,500; the
balance is variable in proportion to the number of machine hours.
 The production overhead costs include a variable cost that is constant per
machine hour at all activity levels, and a stepped fixed cost which changes
when the activity level exceeds 11,000 machine hours.

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A further analysis of the production overhead cost is shown below:

Activity (machine hours) 6,000 9,000 12,000

Costs (£) 64,300 85,300 114,000

Required

(a) Prepare a revised budgetary control statement using the

additional information that you have obtained from the manager of the
precision finishing department.

(b) Explain the weaknesses of an incremental budgeting system. Suggest an

alternative budgeting system that HIP Co. might use, identifying the key
features of this budgeting system and evaluating the advantages of
the alternative system you have suggested.

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Typical discussion questions

Define the “controllability principle” and give arguments for and against its
implementation in determining performance measures.

‘Traditional budgeting systems are incremental in nature and tend to focus on

cost centres. Activity-based budgeting links business planning to the budgeting
process with a view to finding the most cost-effective means of achieving
objectives.’

Requirements

(a) Explain the weaknesses of an incremental budgeting system.

(b) Describe the main features of an activity-based budgeting system and

comment on the advantages claimed for its use.

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Controllability is defined by Horngren, Bhimani et al as “the degree of influence

that a specific manager has over costs, revenues or other items in question”.
Controllability refers to a specific manager – a superior may be able to control a
cost, and for a period of time – all costs are controllable in the long run. The
controllability principle is that managers should only be held responsible for costs
that they have direct control over. So, for example, a divisional manager would
not be held responsible for the allocation of central costs to her department if she
has no control over the incurrence or magnitude of these costs. Under this
principle, it would be held that dysfunctional consequences would arise if
managers were held accountable for costs over which they have no control.

An alternative view argues that there are considerable advantages to be gained

in holding managers responsible for costs even when they do not have any direct
control over them. For example, it stops managers treating some costs as “free
goods” and thus stops them over-using these goods and services. Further,
holding managers responsible for items outside their control may encourage
them to become more involved with such issues and, as a result, the total cost
may be reduced or the goods or services may be provided more efficiently.

There is no clear evidence as to which of these views will produce the best
performance from a division or a division manager.

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(a) Incremental budgeting uses year 1 budget as the starting point for the
preparation of year 2 budget. It is assumed that the basic structure of the old
budget is acceptable and that adjustments will be made to allow for changes in
volume, efficiency and price levels. The focus, therefore, tends to be on the
existing use of resources rather than on identifying objectives and alternative
strategies for the future budget period. It is argued that incremental budgeting
does not question sufficiently the costs and benefits of operating a particular
resource allocation structure.

Incremental budgeting may, therefore, be argued to have weaknesses in that:

 the resource allocation is not clearly linked to a business plan and the
consideration of alternative means of achieving objectives;
 there is a tendency to constrain new high-priority activities;
 there is insufficient focus on efficiency and effectiveness and the alternative
methods by which they may be achieved;
 it often leads to arbitrary cuts being made in order to meet overall financial
targets;
 it tends not to lead to management commitment to the budget process.

(b) The main features and potential advantages of activity-based budgeting

are:

(i) The major focus is on the planning of resource allocation which aims at
efficiency, effectiveness and continuous improvement. Features may
include:
 the impact of change from the present activity levels are made more
apparent;
 key processes and constraints are identified and resource
requirements related thereto are quantified;
 efforts are made to identify critical success factors and the
performance indicators which are most relevant for such factors.
(ii) Activities are seen as the key to effective planning and control.
(iii) It is argued that activities consume resources and that efforts should be
focused on the control of the cause of costs not the point of incidence.
(iv) Costs are traced to activities with the creation of ‘cost pools’ which relate
to an activity.
(v) It is easier to eliminate non-value-adding activities.
(vi) Focus may be on total quality management with emphasis on process
control through identification of cost drivers.

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