Budgeting and Profit Budgeting and Profit PlanningPlanning

BUDGETING AND PROFIT PLANNING

Planning Process

Preparation/Types of Budgets

Budget-Definition, Meaning and Purpose

Planning ProcessPlanning ProcessBudgeting is a tool of planning. Planning involves specification of

the basic objectives that the organisation will pursue and the fundamental policies that will guide it. In operational terms,

it involves four steps:

(1) Objectives

Objectives are broad and long-range desired state or position in future.

(2) Goals

Goals are quantitative targets to be achieved in specified period.

(3) Strategies

Strategies represent specific course of action to achieve goals.

(4) Plans

The final step is the preparation of budgets/profit plans. It converts goals and strategies into annual operating plans..

BudgetBudget

A budget is defined as a comprehensive and coordinated plan, expressed in financial terms, for the operations and resources of an enterprise for some specified period in the future. The essential elements of a budget are:

(1) Plan

(2) Financial terms

(3) Operations and resources

(4) Specific future period

(5) Comprehensive coverage

(6) Coordination

The first ingredient of a budget is its plan. It includes two aspects which have a bearing on the operations of an enterprise. One set of factors, which determine a firm’s future operations are wholly external and beyond its control. The second set of factors affecting future activities are within the firm’s control and discretion, that is, they are internal.

A budget is a mechanism to plan for the firm’s operations and resources. The operations are reflected in revenues and expenses. The plan also covers the resources of the firm. The planning of resources means the planning of the various assets and the sources of capital to finance these assets. The assets could be fixed assets as well as current assets.

Budgets are prepared in financial terms, that is, in terms of monetary value such as the rupee, dollar, and so on. The reason is that the monetary unit is a common denominator.

1. Plan

2. Operations and Resources

3. Financial Terms

A budget relates to a specified period of time, usually one year.

A budget is comprehensive in that all the activities and operations of an organisation are included in it. It covers the organisation as a whole and not only some segments. The modus operandi is that budgets are prepared for each segment/facet/activity/division of an organisation.

Budgets are prepared for the different components/ segments/divisions/ facets/activities of an organisation so as to take care of the situations and problems of each component. The budgets for each of the components are prepared in harmony with each another. This is called coordination.

4. Specified Future Period

5. Comprehensiveness

6. Coordination

Budget PurposeBudget Purpose

The main objectives of budgeting are:

1. Explicit statement of expectations

2. Communication

3. Coordination,

4. Expectations as a framework for judging performance

One purpose of budgeting is to state expectations in formal terms so that most of the underlying assumptions may be identified. A firm has the

basic objective of optimising long-run profit. Its long-range goals also include survival, consumer satisfaction, employee

welfare, personal power and prestige, and so on.

Another purpose of budgeting is to communicate or inform others of the goals and methods selected by top management. Since budgeting

deals with fundamental policies and objectives, it is prepared by top management.

However, a budget does not lay down a statement of expectations in rigid terms. A budget should be modified when necessary in the light of

the changes in the factors/assumptions on which the original estimates were based.

1. Explicit Statement of Expectations

2. Communication  

 Yet another purpose of budgeting is coordination. The term ‘coordination’ refers to the operation of all departments of an organisation in

such a way that there is no bottleneck or imbalance.

Finally, a budget establishes expectations as a framework for judging employee performance.

In view of the above, coordination is a major function of budgeting. Budgets should be drafted in such a way that the operations

of the various departments are related to each other for the achievement of the overall goal.

3. Coordination

4. Expectations as a Framework for Judging Performance  

TYPES OF BUDGETSTYPES OF BUDGETS

The overall budget is known as the master budget. A master budget normally consists of three

types of budgets:

(i) Operating Budgets (i) Operating Budgets

(ii) Financial Budgets(ii) Financial Budgets

(iii) Special Decision Budgets (iii) Special Decision Budgets

1. Operating Budget1. Operating Budget

1) Sales budget,2) Production budget,3) Purchase budget,4) Direct labour budget,5) Manufacturing expenses budget, and6) Administrative and selling expenses budget, and

so on.

Operating budgets relate to physical activities/ operations such as sales, production,

and so on.

Operating budget has the following components

2. Financial Budget2. Financial Budget

1) Budgeted income statement,

2) Budgeted statement of retained earnings,

3) Cash budget, and

4) Budgeted balance sheet.

Financial budgets are concerned with expected cash flows, financial position and

result of operations.

Financial budget has the following components

Cash BudgetCash BudgetCash budget is a device to help a firm to plan for and control the use of cash. It is a statement showing the estimated cash inflows and cash outflows over the planning period. The principal aim of the cash budget, as a tool to predict cash flows over a period of time, is to ascertain whether there is likely to be excess/shortage of cash at any time.

The preparation of a cash budget involves several steps.

The first element of a cash budget is the selection of the period of the budget, that is, the planning horizon.

The second element of the cash budget is the selection/identification of the factors that have a bearing on cash flows.

The factors that generate cash are generally divided into two broad categories:

(i) Operating (ii) Financial

Operating Cash FlowOperating Cash Flow

The main operating factors/items which generate cash outlfows and inflows over the time span of a

cash budget are tabulated in Exhibit 1.

Exhibit 1.  Operating Cash Flow Items

Cash inflows/Receipts Cash outflows/Disbursements

1.Cash sales

2.Collection of accounts receivable

3.Disposal of fixed assets

1. Accounts payable/Payable payments

2. Purchase of raw materials

3. Wages and salary (pay roll)

4. Factory expenses

5. Administrative and selling expenses

6. Maintenance expenses

7. Purchase of fixed assets

Financial Cash Flow ItemsFinancial Cash Flow Items

The major financial factors/items affecting generation of cash flows are depicted in Exhibit 2.

Exhibit 2.  Financial Cash Flow Items

Cash inflows/Receipts Cash outflows/Payments

1. Loans/borrowings

2. Sale of securities

3. Interest received

4. Dividend received

5. Rent received

6. Refund of tax

7. Issues of new shares and securities

1. Income tax/tax payments

2. Redemption of loan

3. Re-purchase of shares

4. Interest paid

5. Dividends paid

Example 1  

The following data relate to Hypothetical Limited:

Balance Sheet as at March 31, Current Year

Liabilities Amount Assets Amount

Accounts payable

  (all for March purchases)

Taxes payable

  (all for March income)

Share capital

Retained earnings

Rs 40,000

25,000

11,00,000

10,26,800

_______

21,91,800

Cash

Accounts receivable

  (all from March sales)

Inventories:

  Raw materials (9,600 kgs ×Rs 3)

  Finished goods

    (1,800 units ×Rs 35)

Fixed assets:

  Cost Rs 20,00,000

  Less: Accumulated

        depreciation (4,50,000)

Rs 3,00,000

2,50,000

28,800

63,000

15,50,000

21,91,800

2. Sales forecasts: Assume the marketing department has developed the following sales forecast for the first quarter of the next year and the selling price of Rs 50 per unit.

Month Units sales

 April May June

9,00012,000

16,000

3. The management desires closing inventory to equal 20 per cent of the following month’s sales.

4. The manufacturing costs are as follows

Direct materials: (5 kgs ×Rs 3) (per unit)Direct labourVariable overheadsTotal fixed overheads (per annum)

Rs 1559

7,20,000

5. Normal capacity is 1,20,000 units per annum. Assume absorption costing basis.

6. Each unit of final product requires 5 kgs of raw materials. Assume management desires closing raw material inventory to equal 20 per cent of the following month’s requirements of production.

7. Assume fixed selling and administrative expenses are Rs 20,000 per month and variable selling and administrative expenses are Rs 5 per unit sold.

8. All sales are on account. Payment received within 10 days from the date of sale are subject to a 2 per cent cash discount. In the past, 60 per cent of the sales were collected during the month of sale and 40 per cent are collected during the following month. Of collections during the month of sale, 50 per cent are collected during the discount period. Accounts receivable are recorded at the gross amount and cash discounts are treated as a reduction in arriving at net sales during the month they are taken.

9. Tax rate is 35 per cent.

10. Additional information:(a) All purchases are on account. Two-thirds are paid for in the month

of purchase and one-third, in the following month.(b) Fixed manufacturing costs include depreciation of Rs 20,000 per

month.(c) Taxes are paid in the following month.(d) All other costs and/or expenses are paid during the month in which

incurred.

From the foregoing information prepare a master budget for the month of April only.

Solution

1.Production Budget

Particulars April  May 

Sales (units)

Add: Desired closing inventory (0.20 ×next month’s sales)

Total finished goods requirement

Less: Opening inventory

Required production (units)

9,000

2,400

11,400

(1,800)

9,600

12,000

3,200

15,200

(2,400)

12,800

2.Manufacturing Cost Budget

 Particulars April 

Required production (units)

Direct material cost (5 kgs ×Rs 3 per kg)

Total direct material cost

Total direct labour cost (Rs 5 per unit)

Total variable overhead cost (Rs 9 per unit)

Total variable manufacturing costs

All fixed manufacturing overheads (Rs 7,20,000 ÷ 12 months)

Total manufacturing cost

9,600

×Rs 15

Rs 1,44,000

48,000

86,400

2,78,400

60,000

3,38,400

3.Purchase Budget (Raw Materials)

Particulars April  May 

Production requirement (units)Raw material required for production @ 5 kgs per unit (kgs) Add: Desired closing inventory (0.20 ×May requirements)Total requirements Less: Opening inventoryPurchase requirementPurchase requirement (amount @ Rs 3 per kg)

9,600______48,000

12,80060,800(9,600)

51,200Rs 1,53,600

12,800_____64,000

4.Selling and Administrative Expenses Budget

 Particulars April 

Units salesVariable costs @ Rs 5 per unitFixed costsTotal selling and administrative expenses

9,000Rs 45,000

20,00065,000

5. Cost of Goods Sold Budget

 Particulars April 

Units soldCost per unit

VariableFixed (Rs 60,000 ÷ 10,000 units)

Total cost

Rs 29 6

9,000

×Rs 353,15,000

6. Budgeted Income Statement for the Month of April

Gross sales (9,000 ×Rs 50)Less: Cash discount (Rs 4,50,000 ×0.6 ×0.5 ×0.02)

Net salesLess: Cost of goods sold

Gross margin (unadjusted)Less: Capacity variance unfavourable (400 units ×Rs 6)

Gross margin (adjusted)Less: Selling and administrative expenses

Earnings before taxesLess: Taxes (0.35)

Earning after taxes

Rs 4,50,000 2,700

4,47,3003,15,0001,32,300

2,4001,29,900

65,00064,90022,71542,185

7.Budgeted Statement of Retained EarningsOpening balanceAdd: Earnings after taxesClosing balance

Rs 10,26,800 42,185

10,68,985 8.Cash Budget (April)Opening balanceCash inflows: Collection from debtors:March salesApril sales (gross) (Rs 4,50,000 × 0.60)Less: Cash discount  (Rs 2,70,000 ×0.5 ×0.02)Cash outflows: Payment to creditors:  For March purchases  For April purchases (Rs 1,53,600 ×2/3)Direct labourVariable manufacturing overheadFixed manufacturing overhead Less: DepreciationVariable selling and administrative overheadsFixed selling and administrative overheadsTaxesClosing balance

Rs 2,70,000

2,700

Rs 2,50,000

2,67,300

40,000

1,02,400

60,000(20,000)

Rs 3,00,000

5,17,300

1,42,40048,00086,400

40,00045,000

20,00025,000

Rs 8,17,300

4,06,8004,10,500

9. Proforma Balance Sheet as at March 31, Next Year

Liabilities Amount Assets Amount

Accounts payable

   (Rs 40,000 +

Rs 1,53,600  –

Rs 1,42,400)

Taxes payable

(Rs 25,000  + Rs 22,715

– Rs 25,000)

Share capital

Retained earnings

Rs 51,200

22,715

11,00,000

10,68,985

________

22,42,900

Cash

Accounts receivable

  (Rs 4,50,000 ×0.40)

Inventories:

  Raw material

  (12,800 ×Rs 3)

  Finished goods

  (2,400 ×Rs 35)

Fixed assets:

  Cost

  Less: Accumulated

    depreciation

Rs 38,400

84,000

20,00,000

(4,70,000)

Rs 4,10,500

1,80,000

1,22,400

15,30,000

22,42,900

Special Decision BudgetsSpecial Decision BudgetsThe third category of budgets are special decision

budgets. They relate to inventory levels, break-even analysis, and so on.

Fixed Budgets

Budgets prepared at a single level of activity, with no prospect of modification in the light of changed circumstances, are referred to as fixed budgets.

Flexible Budgets

The alternative to fixed budgets are flexible/variable/sliding budgets

Fixed and Flexible BudgetsFixed and Flexible Budgets

Flexible BudgetsFlexible BudgetsThe term ‘flexible’ is an apt description of the essential features of these budgets. A flexible budget estimates costs at several levels of activity.

Its merit is that instead of one estimate, it contains several estimates/plans in different assumed circumstances. It is a useful tool in real world situations, that is, unpredictable environment.

A flexible budget, in a sense, is a series of fixed budgets and any increase/decrease in the level/volume of activity must be reflected in it.

Each expense in each department/segment is to be categorised into fixed, variable and mixed components. A budget may first be prepared at the expected level of activity, say, 100 per cent capacity. Additional columns may then be added for costs below and above, 90 per cent and 110 per cent capacity and so on.

The conceptual framework of flexible budgeting relates to: (i) Measure of volume and (ii) Cost behaviour with change in volume

Table 1  Hypothetical Ltd—Flexible Budget (Maintenance Department)

Volume (labour-hours) 4,000 4,500 5,000 5,500 6,000

Variable costs:

Labour

Material

Others

Mixed costs:

Labour

Maintenance

Other supplies

Discretionary fixed costs:

Training

Experimental methods

Committed fixed costs:

Depreciation

Rent, lease cost

Total

Rs 6,000

2,400

800

2,300

1,400

2,500

1,500

3,500

5,000

3,500

28,900

Rs 6,750

2,700

900

2,400

1,450

2,750

2,000

4,000

5,000

3,500

31,450

Rs 7,500

3,000

1,000

2,500

1,500

3,000

2,000

4,000

5,000

3,500

33,000

Rs 8,250

3,300

1,100

2,600

1,550

3,250

2,000

4,000

5,000

3,500

34,550

Rs 9,000

3,600

1,200

2,700

1,600

3,500

2,500

4,500

5,000

3,500

37,100

Table 2: Hypothetical Ltd—Flexible Budget (Manufacturing Department)

Volume (machine-hours) 50 60 70 80 90

Variable costs:

Power

Helpers

Discretionary fixed costs:

Training

Tools

Committed fixed costs:

Depreciation

Rent

Total

Rs 500

250

800

200

1,200

1,000

3,950

Rs 600

300

900

200

1,200

1,000

4,200

Rs 700

350

900

200

1,200

1,000

4,350

Rs 800

400

900

300

1,200

1,000

4,600

Rs 900

450

1,000

300

1,200

1,000

4,850