CIMA - C1 Fundamentals of Management Accounting
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9: Budget preparation ⏐ Part C Financial planning and control
1 Why do organisations prepare budgets?
Budgeting is a multi-purpose activity.
1.1 Reasons for preparing budgets
Here are some of the reasons why budgets are used.
Function Detail
Compel planning
Budgeting forces management to look ahead, to set out detailed plans for
achieving the targets for each department, operation and (ideally) each manager
and to anticipate problems.
Communicate ideas and plans
A formal system is necessary to ensure that each person affected by the plans is
aware of what he or she is supposed to be doing. Communication might be one-
way, with managers giving orders to subordinates, or there might be a two-way
communication .
Coordinate activities
The activities of different departments need to be coordinated to ensure everyone in
an organisation is working towards the same goals. This means, for example, that the
purchasing department should base its budget on production requirements and that
the production budget should in turn be based on sales expectations.
Provide a framework for
responsibility accounting
Budgets require that managers are made responsible for the achievement of
budget targets for the operations under their personal control.
Establish a system of control
Control over actual performance is provided by the comparisons of actual results
against the budget plan. Departures from budget can then be investigated and the
reasons for the departures can be divided into controllable and uncontrollable
factors.
Provide a means of performance
evaluation
Budgets provide targets which can be compared with actual outcomes in order to
assess employee performance.
Motivate employees to improve
their performance
The interest and commitment of employees can be retained if there is a system
that lets them know how well or badly they are performing. The identification of
controllable reasons for departures from budget with managers responsible
provides an incentive for improving future performance.
Here's what the Official Terminology has to say:
Budget purposes: 'Budgets may help in authorising expenditure, communicating objectives and plans, controlling
operations, co-ordinating activities, evaluating performance, planning and rewarding performance. Often, reward
systems involve comparison of actual with budgeted performance.' CIMA Official Terminology
Key term
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Part C Financial planning and control ⏐ 9: Budget preparation
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1.2 Different things to different people
A budget, since it has different purposes, might mean different things to different people.
A budget might be a forecast, a means of allocating resources, a yardstick or a target.
What it might mean Detail
Forecast
It helps managers to plan for the future. Given uncertainty about the future, however, it is
quite likely that a budget will become outdated as events occur and so the budget will cease
to be a realistic forecast. New forecasts might be prepared that differ from the budget. (A
forecast is what is likely to happen; a budget is what an organisation wants to happen.
These are not necessarily the same thing.)
Means of allocating
resources
It can be used to decide how many resources are needed (cash, labour and so on) and how
many should be given to each area of the organisation's activities. As we saw when we
looked at limiting factor analysis, resource allocation is particularly important when some
resources are in short supply. Budgets often set ceilings or limits on how much
administrative departments and other service departments are allowed to spend in the
period. Public expenditure budgets, for example, set spending limits for each government
department.
Yardstick
By comparing it with actual performance, the budget provides a means of indicating where
and when control action may be necessary (and possibly where some managers or
employees are open to censure for achieving poor results).
Target
A budget might be a means of motivating the workforce to greater personal
accomplishment, another aspect of control.
A budget is a 'quantitative expression of a plan for a defined period of time. It may include planned sales volumes and
revenues; resource quantities, costs and expenses; assets, liabilities and cash flows.' CIMA Official Terminology
2 A framework for budgeting
2.1 Budget committee
The budget committee is the coordinating body in the preparation and administration of budgets.
The budget committee is usually headed up by the managing director (as chairman) and is assisted by a budget officer
who is usually an accountant. Every part of the organisation should be represented on the committee, so there should be
a representative from sales, production, marketing and so on. Functions of the budget committee include the following.
• Coordination and allocation of responsibility for the preparation of budgets
• Issuing of the budget manual
• Timetabling
• Provision of information to assist in the preparation of budgets
• Communication of final budgets to the appropriate managers
• Monitoring the budgeting process by comparing actual and budgeted results
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FAST FORWA
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9: Budget preparation ⏐ Part C Financial planning and control
2.2 The budget period
A budget period is a 'period for which a budget is prepared, and used, which may then be sub-divided into control
periods'. CIMA Official Terminology
Except for capital expenditure budgets, the budget period is usually the accounting year (sub-divided into 12 or 13
control periods).
2.3 Responsibility for budgets
The manager responsible for preparing each budget should ideally be the manager responsible for carrying out the
budget.
For example, the preparation of particular budgets might be allocated as follows.
(a) The sales manager should draft the sales budget and the selling overhead cost centre budgets.
(b) The purchasing manager should draft the material purchases budget.
(c) The production manager should draft the direct production cost budgets.
Question
Budget committee
Which of the following is the budget committee not responsible for?
A Preparing functional budgets
B Timetabling the budgeting operation
C Allocating responsibility for the budget preparation
D Monitoring the budgeting process
Answer
The correct answer is A.
The manager responsible for implementing the budget that must prepare it, not the budget committee.
If you don't know the answer, remember not to fall for the common pitfall of thinking, 'Well, we haven't had a D for a
while, so I'll guess that'. It is good practice to guess if you don't know the answer (never leave out an assessment
question) but first eliminate some of the options if you can.
Since the committee is a co-ordinating body we can definitely say that they are responsible for B and D. Similarly, a co-
ordinating body is more likely to allocate responsibility than to actually undertake the budget preparation, so eliminate C
and select A as the correct answer.
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2.4 The budget manual
The budget manual is a collection of instructions governing the responsibilities of persons and the procedures, forms
and records relating to the preparation and use of budgetary data.
The budget manual is a 'detailed set of guidelines and information about the budget process typically including a
calendar of budgetary events, specimen budget forms, a statement of budgetary objectives and desired results, listing of
budgetary activities and budget assumptions, regarding, for example, inflation and interest rates'.
CIMA Official Terminology
A budget manual may contain the following.
(a) An explanation of the objectives of the budgetary process
(i) The purpose of budgetary planning and control
(ii) The objectives of the various stages of the budgetary process
(iii) The importance of budgets in the long-term planning of the business
(b) Organisational structures
(i) An organisation chart
(ii) A list of individuals holding budget responsibilities
(c) An outline of the principal budgets and the relationship between them
(d) Administrative details of budget preparation
(i) Membership and terms of reference of the budget committee
(ii) The sequence in which budgets are to be prepared
(iii) A timetable
(e) Procedural matters
(i) Specimen forms and instructions for their completion
(ii) Specimen reports
(iii) Account codes (or a chart of accounts)
(iv) The name of the budget officer to whom enquiries must be sent
3 Steps in the preparation of a budget
The first task in the budgetary process is to identify the principal budget factor. This is also known as the key budget
factor or limiting budget factor. The principal budget factor is the factor which limits the activities of an organisation.
The procedures for preparing a budget will differ from organisation to organisation but the steps described below will be
indicative of the steps followed by many organisations. The preparation of a budget may take weeks or months and the
budget committee may meet several times before the master budget (budgeted income statement, budgeted statement
of financial position and budgeted cash flow) is finally agreed. Functional budgets (sales budgets, production budgets,
direct labour budgets and so on), which are amalgamated into the master budget, may need to be amended many times
over as a consequence of discussions between departments, changes in market conditions and so on during the course
of budget preparation.
FAST FORWARD
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9: Budget preparation ⏐ Part C Financial planning and control
3.1 Identifying the principal budget factor
The principal budget factor 'limits the activities of an undertaking. Identification of the principal budget factor is often
the starting point in the budget setting process. Often the principal budget factor will be sales demand but it could be
production capacity or material supply.' CIMA Official Terminology
The principal budget factor is usually sales demand. A company is usually restricted from making and selling more of
its products because there would be no sales demand for the increased output at a price which would be
acceptable/profitable to the company. The principal budget factor may also be machine capacity, distribution and selling
resources, the availability of key raw materials or the availability of cash. Once this factor is defined then the remainder
of the budgets can be prepared. For example, if sales are the principal budget factor then the production manager can
only prepare his budget after the sales budget is complete.
3.2 The order of budget preparation
Assuming that the principal budget factor has been identified as being sales, the stages involved in the preparation of a
budget can be summarised as follows.
(a) The sales budget is prepared in units of product and sales value. The finished goods inventory budget
can be prepared at the same time. This budget decides the planned increase or decrease in finished goods
inventory levels.
(b) With the information from the sales and inventory budgets, the production budget can be prepared. This
is, in effect, the sales budget in units plus (or minus) the increase (or decrease) in finished goods
inventory. The production budget will be stated in terms of units.
(c) This leads on logically to budgeting the resources for production. This involves preparing a materials
usage budget, machine usage budget and a labour budget.
(d) In addition to the materials usage budget, a materials inventory budget will be prepared, to decide the
planned increase or decrease in the level of inventory held. Once the raw materials usage requirements
and the raw materials inventory budget are known, the purchasing department can prepare a raw
materials purchases budget in quantities and value for each type of material purchased.
(e) During the preparation of the sales and production budgets, the managers of the cost centres of the
organisation will prepare their draft budgets for the department overhead costs. Such overheads will
include maintenance, stores, administration, selling and research and development.
(f) From the above information a budgeted income statement can be produced.
(g) In addition several other budgets must be prepared in order to arrive at the budgeted statement of
financial position. These are the capital expenditure budget (for non-current assets), the working capital
budget (for budgeted increases or decreases in the level of receivables and accounts payable as well as
inventories), and a cash budget.
Make sure that you understand the meaning of principal budget factor.
Key term
Assessment
focus point
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4 Functional budgets
Functional/departmental budgets include budgets for sales, production, purchases and labour.
A departmental/functional budget is a 'budget of income and/or expenditure applicable to a particular function
frequently including sales budget, production cost budget (based on budgeted production, efficiency and utilisation),
purchasing budget, human resources budget, marketing budget and research and development budget'.
CIMA Official Terminology
Having seen the theory of budget preparation, let us look at functional (or departmental) budget preparation, which are
best explained by means of an example.
4.1 Example: preparing a materials purchases budget
ECO Co manufactures two products, S and T, which use the same raw materials, D and E. One unit of S uses 3 litres of D
and 4 kilograms of E. One unit of T uses 5 litres of D and 2 kilograms of E. A litre of D is expected to cost $3 and a
kilogram of E $7.
Budgeted sales for 20X2 are 8,000 units of S and 6,000 units of T; finished goods in inventory at 1 January 20X2 are
1,500 units of S and 300 units of T, and the company plans to hold inventories of 600 units of each product at 31
December 20X2.
Inventories of raw material are 6,000 litres of D and 2,800 kilograms of E at 1 January and the company plans to hold
5,000 litres and 3,500 kilograms respectively at 31 December 20X2.
The warehouse and stores managers have suggested that a provision should be made for damages and deterioration of
items held in store, as follows.
Product S: loss of 50 units Material D: loss of 500 litres
Product T: loss of 100 units Material E: loss of 200 kilograms
Required
Prepare a material purchases budget for the year 20X2.
Solution
To calculate material purchases requirements it is first necessary to calculate the material usage requirements. That in
turn depends on calculating the budgeted production volumes.
Product S
Product T
Units
Units
Production required
To meet sales demand
8,000
6,000
To provide for inventory loss
50
100
For closing inventory
600
600
8,650
6,700
Less inventory already in hand
1,500
300
Budgeted production volume
7,150
6,400
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9: Budget preparation ⏐ Part C Financial planning and control
Material D
Material E
Litres
Kgs
Usage requirements
To produce 7,150 units of S
21,450
28,600
To produce 6,400 units of T
32,000
12,800
To provide for inventory loss
500
200
For closing inventory
5,000
3,500
58,950
45,100
Less inventory already in hand
6,000
2,800
Budgeted material purchases
52,950
42,300
Unit cost
$3
$7
Cost of material purchases
$158,850
$296,100
Total cost of material purchases
$454,950
The basics of the preparation of each functional budget are similar to those above. Work carefully through the following
question which covers the preparation of a number of different types of functional budget.
Question
Functional budgets
XYZ company produces three products X, Y and Z. For the coming accounting period budgets are to be prepared based
on the following information.
Budgeted sales
Product X 2,000 at $100 each
Product Y 4,000 at $130 each
Product Z 3,000 at $150 each
Budgeted usage of raw material
RM11 RM22 RM33
Product X 5 2 –
Product Y 3 2 2
Product Z 2 1 3
Cost per unit of material $5 $3 $4
Finished inventories budget
Product X Product Y Product Z
Opening 500 800 700
Closing 600 1,000 800
Raw materials inventory budget
RM11 RM22 RM33
Opening 21,000 10,000 16,000
Closing 18,000 9,000 12,000
Product X Product Y Product Z
Expected hours per unit 4 6 8
Expected hourly rate (labour) $9 $9 $9
Important!
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Fill in the blanks.
(a) Sales budget
Product X Product Y Product Z Total
Sales quantity
Sales value $
$ $
$
(b) Production budget
Product X Product Y Product Z
Units Units Units
Budgeted production
(c) Material usage budget
RM11 RM22 RM33
Units Units Units
Budgeted material usage
(d) Material purchases budget
RM11 RM22 RM33
Budgeted material purchases $
$ $
(e) Labour budget
Budgeted total wages $
Answer
(a) Sales budget
Product X
Product Y
Product Z
Total
Sales quantity
2,000
4,000
3,000
Sales price
$100
$130
$150
Sales value
$
200,000
$
520,000
$
450,000
$
1,170,000
(b) Production budget
Product X
Product Y
Product Z
Units
Units
Units
Sales quantity
2,000
4,000
3,000
Closing inventories
600
1,000
800
2,600
5,000
3,800
Less opening inventories
500
800
700
Budgeted production
2,100
4,200
3,100
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9: Budget preparation ⏐ Part C Financial planning and control
(c) Material usage budget
Production
RM11
RM22
RM33
Units
Units
Units
Units
Product X
2,100
10,500
4,200
–
Product Y
4,200
12,600
8,400
8,400
Product Z
3,100
6,200
3,100
9,300
Budgeted material
usage
29,300
15,700
17,700
(d) Material purchases budget
RM11
RM22
RM33
Units
Units
Units
Budgeted material usage
29,300
15,700
17,700
Closing inventories
18,000
9,000
12,000
47,300
24,700
29,700
Less opening inventories
21,000
10,000
16,000
Budgeted material purchases
26,300
14,700
13,700
Standard cost per unit
$5
$3
$4
Budgeted material purchases
$
131,500
$
44,100
$
54,800
(e) Labour budget
Hours required Total
Rate per
Product
Production
per unit
hours
hour
Cost
Units
$
$
X
2,100
4
8,400
9
75,600
Y
4,200
6
25,200
9
226,800
Z
3,100
8
24,800
9
223,200
Budgeted total wages
525,600
You may get an assessment question which asks you to work out one budgeted figure from another. For example you
may be given the sales budget and asked to work out the production budget. Make sure that you learn this formula.
Units made = units sold + units in closing inventory – units in opening inventory.
The business must produce enough to cover its sales volume and to leave enough in closing inventory, but it gets a
'head start' from opening inventory. This is why opening inventory is deducted.
You can apply this principle to other areas of budgeting. For example
Materials purchases = materials usage + closing inventory material – opening inventory material.
Assessment
focus point
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Question
The following information is available for B Co.
Budgeted annual sales 100,000 units
Opening inventory 25,000 units
Closing inventory 27,500 units
What is the number of units of production for the year?
A 72,500 C 100,000
B 97,500 D 102,000
Answer
D 102,500
Units made = units sold + closing inventory units – opening inventory units
= 100,000 + 27,500 – 25,000
= 102,500
5 Cash budgets
A cash budget is a statement in which estimated future cash receipts and payments are tabulated in such a way as to
show the forecast cash balance of a business at defined intervals.
A cash budget is a 'detailed budget of estimated cash inflows and outflows incorporating both revenue and capital
items'. CIMA Official Terminology
5.1 Preparing cash budgets
For example, in December 20X2 an accounts department might wish to estimate the cash position of the business during
the three following months, January to March 20X3. A cash budget might be drawn up in the following format.
Jan
Feb
Mar
$
$
$
Estimated cash receipts
From accounts payable
14,000
16,500
17,000
From cash sales
3,000
4,000
4,500
Proceeds on disposal of non-current assets
2,200
Total cash receipts
17,000
22,700
21,500
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