ACCA F2 Management Accounting - 2010 - Study text - Emile Woolf Publishing
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Chapter 11: Budgeting
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Preparing functional budgets
The sales budget
The production budget
The materials usage budget
The materials purchases budget
The labour budget
Overheads budgets
2 Preparing functional budgets
This section describes the approach that can normally be used to prepare functional
budgets for a manufacturing organisation. In practice, budgets are usually prepared
with a computer model, such as a spreadsheet. However, you need to understand
the logic of budget preparation.
2.1 The sales budget
The sales budget is the plan for the volume and value of sales in the budget period.
It is prepared for each product individually, in units of sale and sales revenue, and
for sales revenue in total.
It is calculated for each product simply by multiplying the volume of sales in units
by the budgeted sales price per unit.
Example
A company makes and sells two products, Product P and Product Q.
The sales price and expected sales volume for each product next year are as follows:
Product P
Product Q
Sales price per unit $20
$30
Budgeted sales volume 20,000 units
30,000 units
A sales budget can be prepared as follows.
Product
Budgeted
sales quantity
Budgeted
sales price
Budgeted
sales
revenue
units
$
$
P 20,000
20
400,000
Q 30,000
30
900,000
Total
1,300,000
Sometimes, a sales budget is prepared by making adjustments to actual sales in the
current financial year.
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Example
A company is preparing its sales budget for the year. In the current financial year it
expects that total sales will be $2.6 million. Next year it hopes to raise its selling
prices by 3% and to increase sales volume by 5%.
The sales budget for next year is therefore: $2.6 million × 1.03 × 1.05 = $2.8 million
(to the nearest $100,000).
2.2 The production budget
The production budget is calculated initially in units of output, although a budget
for production costs can be prepared when production quantities have been
decided. The production budget in units is prepared for each product, as follows:
Units
Sales budget in units S
Plus: Budgeted closing inventory C
Minus: Opening inventory (O)
Production budget (S + C – O)
In other words, the production budget for each product in units is:
the sales budget in units
plus any planned increase in finished goods inventories (and work-in-progress
inventories)
or minus the opening inventories of finished goods (and work in progress).
Example
A company makes and sells two products, Product P and Product Q. Its sales
budget for next year is to sell 20,000 units of Product P and 30,000 units of Product
Q.
It expects opening inventory of finished goods to be 4,000 units of Product P and
500 units of Product Q. It has been decided that inventory of Product P should be
reduced to 2,000 units by the end of the budget period, and inventory of Product Q
should be increased to 1,500 units.
A production budget can be prepared as follows.
Product P Product Q
units units
Sales budget 20,000
30,000
Plus: Budgeted closing inventory 2,000
1,500
Minus: Opening inventory (4,000)
(500)
Production budget 18,000
31,000
Chapter 11: Budgeting
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2.3 The materials usage budget
After the production budget has been prepared, budgets can be prepared for the
resources required to achieve the production targets. Production resources budgets
will include a materials usage budget, a direct labour budget and possibly a
machine hours budget.
Separate budgets can be prepared for each production centre, and these can be
added together to create the total production budget. For example, if a
manufacturing process consists of a machining department, a finishing department
and an assembly department, production budgets will be prepared for each
department separately, and these will then be combined to produce a total
production department.
The materials usage budget is a budget for the quantities of materials that will be
used. It is a statement of the quantities of direct materials required for production,
and their cost. The usage budget is prepared for each item of material separately,
and a total cost of the materials used should also be shown.
Example
A company makes and sells two products, Product S and Product T. Its production
budget for next year is to make 40,000 units of Product S and 10,000 units of Product
T.
The materials required to make one unit of each product, and their cost, are as
follows.
Product S
Product T
Cost per
kilo
kilos
kilos
Material M1 2.0
3.0
$0.4
Material M 2 2.5
1.5
$0.6
A materials usage budget can be prepared as follows.
Material M1
Material M2
Total
kilos
kilos
To make 40,000 S 80,000
100,000
To make 10,000 T 30,000
15,000
Total quantities 110,000
115,000
Price per kilo $0.4
$0.6
Total cost $44,000
$69,000
$113,000
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2.4 The materials purchases budget
The budgeted cost of materials for use in production is not the same as the quantity
and cost of materials that will be purchased. Material purchases and material usage
will be different if there are plans to increase or reduce raw materials inventories.
The materials purchases budget is the budget for the purchase cost of materials that
will be purchased in the budget period. The materials purchases budget might be
prepared for all materials, direct and indirect, or for direct materials only.
The purchases budget differs from the materials usage budget by the amount of the
planned increase or decrease in inventory levels of materials in the budget period.
The purchase quantities are calculated first. Purchase quantities are calculated as
follows, for each item of material:
Units
Material usage budget in units M
Plus budgeted closing inventory C
Minus opening inventory (O)
Purchases budget, in units (M + C – O)
The purchase quantities for each item of material are converted into a purchases
cost at the budgeted purchase price for the item of material.
The total material purchases budget (in $) is the sum of the purchases budget for
each of the individual items of material.
Example
A company makes and sells two products, Product X and Product Y. Its production
budget for next year is to make 20,000 units of Product X and 15,000 units of Product
Y.
The materials required to make one unit of each product, and their cost, are as
follows.
Product X
Product Y
Cost per
litre
litres
litres
Material M3 0.5
1.5
$3
Material M 4 1.0
2.0
$4
The company expects to have opening inventory of 3,000 litres of Material M3 and
2,000 litres of Material M4. It plans to have closing inventory of 3,500 litres of
Material M3 and 1,200 litres of Material M4
The materials purchases budget can be calculated as follows, after a production
budget has been established.
Chapter 11: Budgeting
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Material M3
Material M4
Total
litres
litres
To make 20,000 X 10,000
20,000
To make 15,000 Y 22,500
30,000
Material usage quantities 32,500
50,000
Closing inventory 3,500
1,200
Opening inventory (3,000)
(2,000)
33,000
49,200
Price per litre $3
$4
Total cost $99,000
$196,800
$295,800
2.5 The labour budget
Direct labour budget
The direct labour budget is prepared in a similar way to the materials usage budget.
It is a statement of the quantities of direct labour required for production, and its
cost.
The budget is prepared for different grades of labour separately, but the total labour
cost should also be shown.
For each grade of labour, the expected hours of work should be calculated, for
making the budgeted production quantities of product individually and then for all
the products in total. The total budget in hours for each grade of labour is converted
into a cost at the standard/budgeted rate per hour for the grade of labour.
Example
A company makes and sells two products, Product S and Product T. Its sales budget
is to sell 40,000 units of Product S and 10,000 units of Product T. The expected
opening inventories of finished goods are 500 units of Product S and 1,000 units of
Product T, and the plan is to double finished goods inventories by the end of the
budget period.
The direct labour hours required to make one unit of each product, and their cost,
are as follows.
Product S
Product T
Cost per
hour
hours
hours
Grade G1 labour 0.2
0.6
$20
Grade G2 labour 0.3
0.8
$16
A direct labour budget can be prepared as follows, after a production budget has
been established.
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Product S Product T
units units
Sales budget 40,000
10,000
Plus: Budgeted closing inventory 1,000
2,000
Minus: Opening inventory (500)
(1,000)
Production budget 40,500
11,000
Grade G1
Grade G2
Total
hours
hours
To make 40,500 S 8,100
16,200
To make 11,000 T 6,600
8,800
Total labour hours 14,700
25,000
Rate of pay per hour $20
$16
Total direct labour cost $294,000
$400,000
$694,000
Indirect labour costs
Budgets must also be prepared for indirect labour employees. It is usual to include
indirect labour costs within the budget for the overhead cost centre or department
where the employees work.
2.6 Overheads budgets
Overheads budgets are prepared for each department or cost centre, in production,
administration and sales and distribution.
To prepare expenditure budgets for each overhead cost centre, overhead
expenditure is allocated and apportioned, using the methods described in the
earlier chapter on overhead costs.
In an absorption costing system, an overhead absorption rate should then be
calculated from the total budgeted expenditure and the budgeted volume of
activity.
When flexed budgets are prepared, overhead costs might be divided into variable
and fixed costs.
Example
A company makes and sells one product, Product Z. The production budget is to
make and sell 5,000 units of Product Z, but there is a possibility that sales demand
might be less than expected; therefore management have decided to prepare a
budget for 4,000 units of production and sales.
Production overhead costs are expected to be fixed costs of $360,000 plus variable
overheads of $1.50 per direct labour hour. Product Z takes 2 hours to produce.
Chapter 11: Budgeting
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A production overheads budget can be prepared at production volumes of both
4,000 and 5,000 units, as follows.
4,000 units 5,000 units
$ $
Variable overheads (2 hours × $1.50 = $3 per unit)
12,000 15,000
Fixed overheads 360,000 360,000
Total overheads 372,000 375,000
Overhead cost per unit $93 $75
Exercise 1
A company produces Products A and B and the budgeted production in the
coming year is 5,000 units of A and 10,000 units of B. Products A and B require the
following quantities of raw materials to produce one unit.
Product A
Product B
per unit
per unit
Raw material X 5 kg
4 kg
Raw material Y 7 kg
3 kg
Raw material X costs $10 per kg and raw material Y costs $20 per kg.
Data relating to opening and closing inventory is as follows.
Raw material
X
Y
Closing inventory 10,000
8,000
Opening inventory 8,000
4,000
Required
Prepare the materials usage and purchases budget for the year.
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Fixed, flexible and flexed budgets
Budgetary control
Fixed budgets
Flexed budgets
Flexible budgets
3 Fixed, flexible and flexed budgets
3.1 Budgetary control
One of the main purposes of budgeting is budgetary control and the control of costs.
Costs can be controlled by comparing budgets with the results actually achieved.
Differences between expected results and actual results are known as variances.
Variances can be either favourable (F) or adverse (A) depending on whether the
results achieved are better or worse than expected. Favourable variances increase
profits and adverse variances decrease profits.
There are three different types of budget that you need to know about.
fixed budgets
flexed budgets
flexible budgets.
3.2 Fixed budgets
The original budget prepared at the beginning of a budget period is known as the
fixed budget. A fixed budget is a budget for a specific volume of output and sales
activity, and it is the ‘master plan’ for the financial year that the company tries to
achieve.
The term ‘fixed’ in ‘fixed budget’ means that the output and sales volumes are for a
fixed amount or quantity.
A fixed budget might be suitable as a plan, provided that the business environment
is fairly stable and sales and production volumes should be predictable with
reasonable accuracy. However, a fixed budget is not suitable for the purpose of
budgetary control – reporting differences between actual costs and profits and what
costs and profits should have been. Fixed budgets are not suitable for budgetary
control reporting because the variances calculated with a fixed budget can provide
misleading information
Chapter 11: Budgeting
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Example
A company makes and sells a single product. Its budget for the year was to make
and sell 10,000 units of the product. Actual sales and production were 15,000 units.
The expected results in the fixed budget and actual results are set out and compared
in the table below.
Fixed
budget
Actual
results
Difference
Units 10,000 15,000
$ $
Sales revenue 200,000 286,000 $86,000 Favourable
Materials costs 60,000 94,000 $34,000 Adverse
Labour costs 70,000 97,000 $27,000 Adverse
Variable overheads 20,000 23,000 $3,000 Adverse
Fixed costs 30,000 34,000 $4,000 Adverse
Total costs 180,000 248,000
The total differences calculated in this way, comparing the fixed budget for 10,000
units with the actual results for 15,000 units, do not provide useful information for
management. The differences do not compare ‘like with like’. It should be expected
that when sales and production volumes are higher than the budgeted quantities,
sales revenues and costs will be higher, and profit will be higher.
Much more useful information would be provided by producing a revised budget
based on the actual quantities produced and sold.
3.3 Flexed budgets
A flexed budget is a budget prepared to show the revenue, costs and profits that
should have been expected from the actual volumes of production and sale. A
flexed budget is prepared for the actual volume of sales and output, and it allows
for the fact that sales revenues and variable costs should be expected to increase or
fall with increases or falls in sales and output.
A flexed budget is prepared at the end of the budget period when the actual results
are known. It is used to compare:
the actual results with the flexed budget
the fixed budget with the flexed budget.
If a flexed budget is compared with the actual results for a period, the differences
between the two (variances) are much more meaningful than if the fixed budget and
actual results are compared.
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Example
Taking the previous example which shows a fixed budget and actual results, a
flexed budget would be prepared as follows.
Fixed
budget
Flexed
budget
Actual
results
Difference
Units 10,000 15,000 15,000
$ $ $
Sales revenue 200,000 300,000
286,000 $14,000 Adverse
Materials costs 60,000 90,000
94,000 $4,000 Adverse
Labour costs 70,000 105,000
97,000 $8,000 Favourable
Variable overheads 20,000 30,000
23,000 $7,000 Favourable
Fixed costs 30,000 30,000
34,000 $4,000 Adverse
Total costs 180,000 255,000
248,000
Profit 20,000 45,000
38,000
In the flexed budget, the expected sales revenue and all the expected variable costs
are shown for output and sales of 15,000 units, which is the actual volume. A
comparison of the flexed budget and actual results shows the differences (variances)
between the actual performance and the results that should have been expected for
the actual volume of output and sales.
The table also shows the expected profit in the fixed budget, the expected profit in
the flexed budget and the actual profit obtained in the period.
The expected profit n the fixed budget is $20,000 but in the flexed budget it is
$5,000. By increasing sales from 10,000 units to 15,000 units, the company would
have been expected to earn an additional profit of $25,000.
However, actual profit was only $38,000, which is $7,000 less than in the flexed
budget. This difference is explained by the sum of the variances in the right-
hand column of the table. These variances add up to $7,000 Adverse.
A budgetary control report can be prepared as follows from this information. (F)
represents a favourable variance and (A) represents and adverse variance.
$ $
Original budgeted profit (fixed budget) 20,000
Sales volume variance 25,000 (F)
Flexed budget profit 45,000
Sales price variance 14,000 (A)
Actual sales minus flexed budget costs 31,000
Materials cost variance 4,000
(A)
Labour cost variance 8,000
(F)
Variable overhead cost variance 7,000
(F)
Fixed overhead expenditure variance 4,000
(A)
Total cost variances 7,000 (F)
Actual profit 38,000
Variances are explained in more detail in the next chapter.