CIMA CO1 Official Learning System - Fundamentals of Management Accounting

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Budgeted income statement for the year ended 31 December, year 3

££

Revenue 1,071,000

Opening inventory of raw materials

4

20,000

Purchases of raw materials 253,700

273,700

Closing inventory of raw materials

5

14,000

259,700

Direct wages 448,500

Production overhead 200,000

Production cost of goods completed 908,200

Opening inventory of ﬁ nished goods

4

15,000

923,200

Closing inventory of ﬁ nished goods

5

50,370

Production cost of goods sold 872,830

Gross proﬁ t 198,170

Selling and administration overhead 75,000

Net proﬁ t before taxation 123,170

Taxation 36,951

86,219

Retained earnings b/f 81,000

Retained earnings c/f 167,219

Note 4 : The opening inventory ﬁ gures for raw materials and

ﬁ nished goods are taken from the opening balance sheet.

Note 5 : The closing inventories are calculated as follows:

£

Raw materials:

M: 4,000  £2 8,000

N: 2,000  £3 6,000

14,000

Finished goods:

Alpha: 150  £143.21 21,481.50

Beta: 150  £192.59 28,888.50

50,370.00

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Budgeted balance sheet at 31 December, year 3

Cost Depreciation Net

£££

Non-current assets

Land 50,000 – 50,000

Buildings and equipment

6

520,000 105,000 415,000

570,000 105,000 465,000

Current assets

Inventories

– raw materials 14,000

– ﬁ nished goods 50,370

64,370

Receivables

7

102,000

Cash at bank 41,500

207,870

Current liabilities

Payables

8

118,700

Taxation 36,951

155,651

52,219

517,219

Financed by

Share capital 350,000

Retained earnings 167,219

517,219

£000

Note 6 : Buildings and equipment

Opening cost balance 400

Purchases during year 120

520

Opening depreciation balance 75

Production depreciation 25

Selling depreciation 5

105

Note 7 : Receivables

Opening balance 25

Sales 1,071

Receipts (cash budget) (994)

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££

Note 8 : Closing payables balance

Opening balance of payables 9,000

Material purchases from budget 253,700

Overhead, excluding depreciation: *

Production 175,000

Selling and administration 70,000

507,700

Less payments (from cash budget):

Materials 159,000

Overhead 230,000

389,000

Closing balance of payables 118,700

* The depreciation must be excluded from the overhead because it is not a cash item, i.e. it is

not a payment which must be made to suppliers.

11.7 Rolling budgets

The CIMA Terminology deﬁ nes a rolling budget as a ‘ budget continuously

updated by adding a further accounting period (month or quarter) when the

earliest accounting period has expired. Its use is particularly beneﬁ cial where future

costs and/or activities cannot be forecast accurately ’ .

For example, a budget may initially be prepared for January to December, year 1. At

the end of the ﬁ rst quarter, that is, at the end of March, year 1, the ﬁ rst quarter’s budget is

deleted. A further quarter is then added to the end of the remaining budget, for January

to March, year 2. The remaining portion of the original budget is updated in the light of

current conditions. This means that managers have a full year’s budget always available and

the rolling process forces them continually to plan ahead.

A system of rolling budgets is also known as continuous budgeting . Rolling budgets can

be particularly useful when future events cannot be forecast reliably.

It is not necessary for all of the budgets in a system to be prepared on a rolling basis. For

example, many organisations will use a rolling system for the cash budget only.

In practice, most organisations carry out some form of updating process on all their

budgets, so that the budgets represent a realistic target for planning and control purposes.

The formalised budgetary planning process will still be performed on a regular basis to

ensure a coordinated approach to budgetary planning.

11.8 Budgets for non-operating functions

So far in this chapter, we have been concentrating mainly on budgets for operating func-

tions. You have seen that once the principal budget factor has been identiﬁ ed and budgeted,

most of the operating budgets can be linked to and coordinated with this one. The level of

expenditure is thus directly linked to the level of activity.

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Budgets for non-operating functions such as computer services, and research and devel-

opment are only indirectly linked to activity levels. Determining the level of expenditure

to be included in these non-operating budgets is not quite so straightforward.

11.8.1 Incremental budgeting

Many non-operating budgets are set using an incremental approach. This means that the

budget for each period is based on the budget or actual results for the previous period,

adjusting for any expected changes and inﬂ ation.

This approach is unlikely to result in the optimum allocation of resources. It tends to

perpetuate inefﬁ cient and unnecessary practices, and may result in budget slack , which is

unnecessary expenditure built into the budget.

11.8.2 Zero-based budgeting

Zero-based budgeting (ZBB) was developed as an alternative to the incremental approach.

The CIMA Terminology deﬁ nes ZBB as a ‘ method of budgeting that requires

all costs to be speciﬁ cally justiﬁ ed by the beneﬁ ts expected. ’

Zero-based budgeting is so called because it requires each budget to be prepared and

justiﬁ ed from zero, instead of simply using last year’s budget or actual results as a base.

Incremental levels of expenditure on each activity are evaluated according to the resulting

incremental beneﬁ ts. Available resources are then allocated where they can be used most

effectively.

The major advantage of ZBB exercises is that managers are forced to consider alterna-

tive ways of achieving the objectives for their activity and they are required to justify the

activities which they currently undertake. This helps to eliminate or reduce the incidence

of budget slack , which is the intentional overestimation of expenses and/or underestimation

of revenues in the budgeting process.

A detailed discussion of ZBB is outside the scope of your Fundamentals of

Management Accounting syllabus, but you should be aware that there are a

number of different approaches to budgetary planning.

11.9 Budgetary control information

You have now learned about the basic principles underlying the budgetary planning process.

You have seen how budgets are created to guide and coordinate the activities of individuals

within the organisation, to ensure that the organisation starts out in the right direction.

In the remainder of this chapter, you will see how budgets are used for control purposes

to ensure that the organisation continues in the right direction.

Budgetary control is achieved by comparing the actual results with the budget. The dif-

ferences are calculated as variances and management action may be taken to investigate

and correct the variances if necessary or appropriate.

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●

If costs are higher or revenues are lower than the budget, then the difference is an

adverse variance.

●

If costs are lower or revenues are higher than the budget, then the difference is a favour-

able variance.

11.9.1 Budget centres

The CIMA Terminology deﬁ nes a budget centre as a ‘ section of an entity for

which control may be exercised through prepared budgets ’ .

Each budget centre is often a responsibility centre. Each centre will have its own budget

and a manager will be responsible for managing the centre and controlling the budget.

This manager is often referred to as the budget holder. Regular budgetary control reports

will be sent to each budget holder so that they may monitor their centre’s activities and

take control action if necessary.

11.9.2 Budgetary control reports

If managers are to use the budgets to control effectively, they must receive regular control

information.

The budgetary control reports should be:

(a) Timely . The information should be made available as soon as possible after the end of

the control period. Corrective action will be much more effective if it is taken soon

after the event, and adverse trends could continue unchecked if budgetary reporting

systems are slow.

(b) Accurate . Inaccurate control information could lead to inappropriate management

action. There is often a conﬂ ict between the need for timeliness and the need for accur-

acy. More accurate information might take longer to produce. The design of budgetary

reporting systems should allow for sufﬁ cient accuracy for the purpose to be fulﬁ lled.

(c) Relevant to the recipient . Busy managers should not be swamped with information that

is not relevant to them. They should not need to search through a lot of irrelevant

information to reach the part which relates to their area of responsibility. The natural

reaction of managers in this situation could be to ignore the information altogether.

The budgetary reporting system should ideally be based on the exception principle

which means that management attention is focused on those areas where performance

is signiﬁ cantly different from budget. Subsidiary information could be provided on

those items which are in line with the budget.

Many control reports also segregate controllable and non-controllable costs and rev-

enues, that is, the costs and revenues over which managers can exercise control are

highlighted separately in the reports from those over which they have no control.

A number of accounting packages have the facility to record actual and budget details

against each account code for each budget centre. These may then be printed in the form

of a report.

(d) Communicated to the correct manager . Control information should be directed to the

manager who has the responsibility and authority to act upon it. If the information

is communicated to the wrong manager its value will be immediately lost and any

adverse trends may continue uncorrected. Individual budget holders ’ responsibilities

must be clearly deﬁ ned and kept up to date in respect of any changes.

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11.10 Fixed and flexible budgets

When managers are comparing the actual results with the budget for a period, it is import-

ant to ensure that they are making a valid comparison. The use of ﬂ exible budgets can help

to ensure that actual results are monitored against realistic targets.

11.10.1 Flexible budgets: an example

An example will demonstrate how ﬂ exible budgets may be used.

A company manufactures a single product and the following data show the actual results

for costs for the month of April compared with the budgeted ﬁ gures.

Operating statement for April

Actual Budget Variance

Units produced 1,000 1,200 (200)

£ £ £

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

Note : Variances in brackets are adverse .

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 was 200 less than budget so

some savings in expenditure might be expected. It is not possible to tell from this compari-

son how much of the saving is due to efﬁ cient cost control, and how much is the result of

the reduction in activity.

The type of budget being used here is a ﬁ xed budget. A ﬁ xed budget is one which

remains unchanged regardless of the actual level of activity. In situations where activity

levels are likely to change, and there is a signiﬁ cant proportion of variable costs, it is dif-

ﬁ cult to control expenditure satisfactorily with a ﬁ xed budget.

If costs are mostly ﬁ xed, then changes in activity levels will not cause problems for cost

comparisons with ﬁ xed budgets.

A ﬂ exible budget can help managers to make more valid comparisons. It is designed

to show the allowed expenditure for the actual number of units produced and sold.

Comparing this ﬂ exible budget with the actual expenditure, it is possible to distinguish

genuine efﬁ ciencies.

11.10.2 Preparing a flexible budget

Before a ﬂ exible budget can be prepared, managers must identify which costs are ﬁ xed

and which are variable. The allowed expenditure on variable costs can then be increased

or decreased as the level of activity changes. You will recall that ﬁ xed costs are those costs

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which will not increase or decrease over the relevant range of activity. The allowance for

these items will therefore remain constant.

We can now continue with the example.

Management has identiﬁ ed that the following budgeted costs are ﬁ xed:

£

Direct labour 8,400

Production overhead 18,000

Administration overhead 21,000

Selling and distribution overhead 14,000

It is now possible to identify the expected variable cost per unit produced.

Original

budget

Fixed

cost

Variable

cost

V’ble cost

per unit

(a) (b) (c)  (a)  (b) (c)/1,200

Units produced 1,200

£ £ £ £

Direct material 19,200 – 19,200 16

Direct labour 13,200 8,400 4,800 4

Production overhead 24,000 18,000 6,000 5

Administration overhead 21,000 21,000 – –

Selling and distribution o/head 16,400 14,000 2,400 2

93,800 61,400 32,400 27

Now that managers are aware of the ﬁ xed costs and the variable costs per unit it is

possible to ‘ ﬂ ex ’ the original budget to produce a budget cost allowance for 1,000 units

produced.

The budget cost allowance for each item is calculated as follows:

Cost allowance Budgeted fixed cost

(num

ber of units produ



 cced variable cost per unit)

For the costs that are wholly ﬁ xed or wholly variable, the calculation of the budget cost

allowance is fairly straightfor

ward. The remaining costs are semi-variable, which you will

recall means that they are partly ﬁ xed and partly variable. For example, the budget cost

allowance for direct labour is calculated as follows:

Cost allowance for direct labour £ £ £

8 400 1 000 4 12 400,(, ),

A full ﬂ

exible budget can now be produced.

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Flexible budget comparison for April

Fixed

Cost allowances

Variable Total Actual cost Variance

£££££

Direct material – 16,000 16,000 16,490 (490)

Direct labour 8,400 4,000 12,400 12,380 20

Production overhead 18,000 5,000 23,000 24,120 (1,120)

Administration overhead 21,000 – 21,000 21,600 (600)

Selling and distn. o/h 14,000 2,000 16,000 16,200 (200)

Total cost 61,400 27,000 88,400 90,790 (2,390)

Note : Variances in brackets are adverse.

This revised analysis shows that in fact the cost was £2,390 higher than would have

been expected from a production volume of 1,000 units.

The cost variances in the ﬂ exible budget comparison are almost all adverse. These over-

spendings were not revealed when a ﬁ xed budget was used and managers may have been

under the false impression that costs were being adequately controlled.

11.10.3 The total budget variance

If we now produce a statement showing the ﬁ xed budget, the ﬂ exible budget and the actual

results together, it is possible to analyse the total variance between the original budget and

the actual results.

Fixed budget Flexible budget Actual results

Expenditure

variances

££££

Direct material 19,200 16,000 16,490 (490)

Direct labour 13,200 12,400 12,380 20

Production overhead 24,000 23,000 24,120 (1,120)

Administrative overhead 21,000 21,000 21,600 (600)

Selling and distribution overhead 16,400 16,000 16,200 (200)

93,800 88,400 90,790 (2,390)

5,400 (2,390)

Volume Expenditure

variance variance

3,010

Total variance

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The total variance is therefore made up of two parts:

(1) the volume variance of £5,400 favourable, which is the expected cost saving resulting

from producing 200 units less than budgeted;

(2) the expenditure variance of £2,390 adverse, which is the net total of the over- and

under-expenditure on each of the costs for the actual output of 1,000 units.

Notice that the volume variance is the saving in standard variable cost: 200

units  £27 per unit  £5,400.

In Chapter 5, you learned how some of the expenditure variances can be analysed

between their price and usage elements – for example, how much of the variance is caused

by paying the wrong price per hour of labour (the labour rate variance), or per kilogram of

material (the material price variance), and how much is caused by using the wrong quan-

tity of material or labour (the usage and efﬁ ciency variances).

11.10.4 Using flexible budgets for planning

You should appreciate that while ﬂ exible budgets can be useful for control purposes they

are not particularly useful for planning. The original budget must contain a single target

level of activity so that managers can plan such factors as the resource requirements and

the product pricing policy. This would not be possible if they were faced with a range

of possible activity levels – although managers will of course consider a range of possible

activity levels before they select the target budgeted activity level.

The budget can be designed so that the ﬁ xed costs are distinguished from the variable

costs. This will facilitate the preparation of a budget cost allowance for control purposes at

the end of each period, when the actual activity is known.

11.10.5 Flexible budgets: another example

Now that you have got the idea of how a ﬂ exible budget can be prepared, work through

the following example to consolidate your understanding.

In this example, as in practice, you will need to investigate the cost behaviour patterns

to determine which costs are ﬁ xed, which are variable and which are semi-variable.

The ﬁ rst step in investigating cost behaviour patterns is to look at the cost data. You

should be able to easily spot any ﬁ xed costs because they remain constant when activity

levels change.

The easiest way to identify the behaviour patterns of non-ﬁ xed costs is to divide each

cost ﬁ gure by the related activity level. If the cost is a linear variable cost, then the cost per

unit will remain constant. For a semi-variable cost the unit rate will reduce as the activity

level increases, because the same basic amount of ﬁ xed costs is being spread over a greater

number of units.

You will then need to recall how to use the high–low method to determine the ﬁ xed and

variable elements of any semi-variable costs. Look back to Chapter 1 if you have forgotten

how the high–low method works.

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Example

Lawrence Ltd operates a system of ﬂ exible budgets and the ﬂ exed budgets for expenditure for the ﬁ rst two quar-

ters of year 3 were as follows:

Flexed budgets – quarters 1 and 2

Quarter 1 Quarter 2

Activity

Sales units 9,000 14,000

Production units 10,000 13,000

Budget cost allowances ££

Direct materials 130,000 169,000

Production labour 74,000 81,500

Production overhead 88,000 109,000

Administration overhead 26,000 26,000

Selling and distribution overhead 29,700 36,200

Total budget cost allowance 347,700 421,700

Despite a projected increase in activity, the cost structures in quarters 1 and 2 are expected to continue during

quarter 3 as follows:

(a) The variable cost elements behave in a linear fashion in direct proportion to volume. However, for production

output in excess of 14,000 units the unit variable cost for production labour increases by 50 per cent. This

is due to a requirement for overtime working and the extra amount is payable only on the production above

14,000 units.

(b) The ﬁ xed cost elements are not affected by changes in activity levels.

(c) The variable elements of production costs are directly related to production volume.

(d) The variable element of selling and distribution overhead is directly related to sales volume.

You are required to prepare a statement of the budget cost allowances for quarter 3, when sales were

14,500 units and production was 15,000 units.

Solution

If you divide each cost ﬁ gure by the relevant activity ﬁ gure, you will ﬁ nd that the only wholly variable cost is

direct material, at £13 per unit.

You can also see that the only wholly ﬁ xed cost is administration overhead since this is a constant amount for

both activity levels, £26,000.

For the remaining costs you will need to use the high–low method to determine the ﬁ xed and variable

elements.

Production labour

Production, units £

Quarter 2 13,000 81,500

Quarter 1 10,000 74,000

Change 3,000 7,500

Variable cost per unit

£

£ per unit

Fixed cos



7 500

3000

250

,

.

tt £ £ £81500 2 50 13000 49 000,(. ,),

CIMA CO1 Official Learning System - Fundamentals of Management Accounting

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