CHAPTER 5 BUDGET: PROFIT PLANNING AND CONTROL SYSTEM

LEARNING OBJECTIVES After studying this chapter, students should be able to understand: (i) (ii) (iii) (iv) (v) Objectives of budgeting system Steps in budgeting process Operational budgets Cash budget Aspects of human behavior in budgeting process

INTRODUCTION There are various types of budgets and some of the cost concepts that have been discussed in Chapter 2 will be used in this chapter. Discussion on Budget: Profit Planning and Control System should be initiated with definition of Budget. DEFINITION OF BUDGET Eventually, Budget is a plan for future operations prepared in terms of money and quantity. In a real life as a routine work relating to budget that may be prepared by anyone is a budget of our income and expenditure. Budgeting can be defined as a process of preparing budgets, implementing the approved budgets and controlling the budgeted activities. Apart of budget, there will be a budgetary control for the purpose of controlling the process of budgeting. Budgeting control refers to the controlling process of Budgeting where the actual performance is measured and compared to the budgeted or planned performance. Finally, if any significant deviations occurred from the budget it will be studied to identify inefficiency in operations. Then, management so called for taking the necessary actions to ensure better performance in the future. OBJECTIVES OF BUDGETING SYSTEM Budgetary Control helps the management to identify and correct inefficiencies in operations. However that is not the only objective of budgetary control. The main objectives are listed below: 1. To combine the ideas of all levels of management in the preparation of a budget. 2. To co-ordinate all the activities of the business so that each is part of an integral total. 3. To centralize control i.e. to control each function in obtaining the best possible results. 4. To decentralize (delegate) responsibility to each manager involved with very clear individual goals and for the organization as a whole. 5. To act as a guide for management decision when unforeseeable conditions affect the budget. 6. To plan and control income and expenditure in maximizing profit and minimizing costs. 7. To pinpoint management where action is needed to remedy a situation. 8. To ensure enough sufficient working capital is available for operation of the business. 9. To provide a yardstick against actual result, so that they can comparable.

STEPS IN BUDGETING PROCESS The important stages are as follows: 1. Communicating details of budget policy and guidelines to those people responsible for the preparation of budgets; 2. determining the factor that restricts output; 3. preparation of the sales budget; 4. initial preparation of various budget; 5. negotiation of budgets with superiors; 6. coordination and review of budgets; 7. final acceptance of budgets; 8. on-going review of budgets. OPERATIONAL BUDGET It is known also as a Functional Budget, which is a one relates to any functions undertaken. Functional Budget is a subsidiary to the Master Budget and it is eventually a summary budget incorporating its component functional budgets. The Master Budget is the finally approved, adopted and employed. There are several types of Functional Budgets and very often used are as follows: i) Sales Budget ii) Production Budget iii) Materials Usage and Purchase Budget iv) Production Cost Budget v) Cash Budget These types of Functional Budgets of Sales Budget, Production Budget, Materials Usage and Purchase Budget and Production Cost Budget will be discussed in the following illustration No. 1 and 2 as follows: Illustration 1 Asfahan Sdn. Bhd. manufactures Product X using three different raw materials. The product details are as follows: Selling price per unit RM 250 Material A Material B Material C Direct labour (hours) 8 3kgs 2kgs 4kgs Material price per kg (RM) 3.50 5.00 4.50 labour rate RM 8.00 per hour

The company is considering its budget for next year and has made the following estimates of sales demand for Product X for July to October: July 400 units August 300 units September 600 units October 450 units

It is company policy to hold stocks of finished goods at the end of each month equal to 50% of the following months sales demand, and it is expected that the stock at the start of the budget period will meet this policy. At the end of the production process the products are tested: it is usual for 10% of those tested to be faulty. It is not possible to rectify these faulty units. Raw materials stocks are expected to be as follows on 1 July: Material A 1,000 kgs Material B 400 kgs Material C 600 kgs Stocks are to be increased by 20% in July and then remain at their new level for the foreseeable future. Labour is paid on an hourly rate based on attendance. In addition to the unit direct labour hours shown above, 20% of attendance time is spent on tasks which support production activity. Required: a) Prepare the following budgets for the quarter from July to September inclusive: i) ii) iii) iv)
v)

sales budget in quantity and value production budget in units raw materials usage budget in kgs raw material purchases budget in kgs and value labour requirements budget in hours and value

Solution a) i) Sales budget in quantity and value July 400 100,000 August 300 75,000 September 600 150,000 Total 1,300 325,000

Sales units Sales value (RM) ii) Production budget in units Sales Closing stock Opening stock Goods output required Normal loss (1,325 X 1/9) Production required

RM 1,300 225 1,525 (200) 1,325 147 1,472

iii)

Raw material usage budget Production (units) Material A (at 3 kg per unit) Material B (at 2 kg per unit) Material C (at 4 kg per unit) 1,472 (kg) 4,416 2,944 5,888

iv)

Raw material purchases budget A (kgs) 4,416 200 4,616 3.50 16,156 B (kgs) 2,944 80 3,024 5.00 15,120 C (kgs) 5,888 120 6,008 4.50 27,036 Total

Kgs used Stock increase (20%) Purchases in kgs Unit cost (RM) Purchases cost (RM)

58,312

v)

Labour requirements budget Production in units Unit labour hours Total hours Cost per hour Total cost 1,472 10 14,720 RM 8.00 RM 17,760

Illustration 2 Kay Limited is preparing its annual budgets for the year to 31 December 2005. It manufactures and sells one product, which has a selling price of RM 150. The marketing director believes that the price can be increased to RM 160 with effect from 1 July 2005 and that at this price the sales volume for each quarter of 2005 will be as follows: Quarter 1 2 3 4 Sales volume 40,000 50,000 30,000 45,000

Sales for each quarter of 2005 are expected to be 40,000 units. Each unit of the finished product which is manufactured requires four units of component R and three units of component T, together with a body shell S. These items are purchased from an outside supplier. Currently, prices are: Component R RM 8.00 each Component T RM 5.00 each Shell S RM 30.00 each

The components are expected to increase in price by 10% with effect from 1 April 2005; no change is expected in the price of the shell. Assembly of the shell and components into the finished product requires 6 labour hours, labour is currently paid RM 5.00 per hour. A 4% increase in wage costs is anticipated to take effect from 1 October 2005. Variable overhead costs are expected to be RM 10 per unit for the whole of 2001; fixed production overhead costs are expected to be RM 240,000 for the year and are absorbed on a per unit basis. Stocks on 31 December 2004 are expected to be as follows: Finished units 9,000 units Component R 3,000 units Component T 5,500 units Shell S 500 units Closing stocks at the end of each quarter are to be as follows: Finished units Component R Component T Shell S Required: a) Prepare the following budgets of Kay Limited for the year ending 31 December 2005, showing values for each quarter and the year in total: i) ii) sales budget (in RM and units) production budget (in units) 10% of next quarters sales 20% of next quarters production requirements 15% of next quarters production requirements 10% of next quarters production requirements

iii) iv) Solution a) i)

material usage budget (in units) production cost budget (in RM)

Sales Budget Quarter 1 40,000 150 6,000 Quarter 2 50,000 150 7,500 Quarter 3 30,000 160 4,800 Quarter 4 45,000 160 7,200 Total 165,000

Sales units Unit price (RM) Revenue (RM '000)

25,500

ii)

Production budget (units) Opening stock Production (difference) Closing stock a Sales Note: a 10% of next quarter's sales 9,000 36,000 45,000 5,000 40,000 5,000 48,000 53,000 3,000 50,000 3,000 31,500 34,500 4,500 30,000 4,500 44,500 49,000 4,000 45,000

160,000

iii)

Material usage budget (units) ('000) Component R Component T Shell S 144 (36,000x4) 108 (36,000x3) 36 (36,000x1) ('000) 192 144 48 ('000) 126 94.5 31.5 ('000) 178 133.5 44.5 Total ('000) 640 480 160

iv)

Production cost budget (000) Materials: Component R Component T Shell S Labour (at RM30 per unit) Variable overhead Fixed overhead a Total production cost 1,152 540 1,080 2,772 1,080 360 54 4,266 (000) 1,689.60 792.00 1,440.00 3,921.60 1,440.00 480.00 72.00 5,913.60 (000) 1,108.80 519.75 945.00 2,573.55 945.00 315.00 47.25 3,880.80 (000) 1,566.40 734.25 1,335.00 3,635.65 1,388.40 445.00 66.75 5,535.80

Total (000) 5,516.80 2,586.00 4,800.00 12,902.80

1,600.00 240.00 19,596.20

Note: a Charged out at RM 1.50 per unit of output (RM 240,000/160,000 units)

CASH BUDGET From your knowledge in financial accounting, you may have gathered that cash is one of the important assets of any business and that liquidity of the business will affect its status as a going concern. It would be of great benefit to the company to know the sources and uses of cash available to it to ensure a smooth operation in the immediate future. Thus a cash budget is one of the important budgets prepared in the master budget. The importance of this budget is as follows: i) Liquidity and cash flow are the key features in the control of the working capital (other elements being the control of stock and debtors). Therefore cash budgets needs close attention from managers and accountant. ii) It shows the forecast of the inflow and outflow of cash during the period, on a month by month and finally showing the budgeted cash position at the end of the period. The main functions or objectives of the Cash Budgets Due to its importance, the cash budget is normally prepared with the following functions or objective in mind. a) To ensure that sufficient cash available so that the company can operate efficiently at the levels provided for in the other functional budgets.

b)

To reveal any expected shortage of cash so that action may be taken. For example whether to obtain outside finance i.e. bank loan, bank overdraft or to reschedule timings of income and expenditure. To reveal any expected surplus of cash so that if the management so desires, cash may be invested or loaned to obtain additional income for the company. Illustration 3
Fatin Bhd. is preparing its budget for the next quarter ending 30 September 2005. The following information has been drawn from the budgets prepared.

c)

Sales Value

June July August September June July August Septmber

Direct wages Direct material purchases

RM 12,500 13,600 17,000 16,800 1,300 per month 3,450 3,780 2,890 3,150

a) b) c) d) e) f) g) h) i)

Fatin Bhd. sells 10% for its goods for cash. The remainder of the customers receives one months credit. Payment to creditors are made in the following the purchase. Wages are paid as they are incurred. Fatin Bhd. takes one months credit on all overheads. Production overhead is RM 3,200per month. Selling, distribution and administration overheads amount to RM 1,890 per month. Included in the amounts for overheads given above are depreciation charges of RM 300 and RM 190 respectively. Fatin Bhd. expects to purchase a delivery vehicle in August for a cash payment of RM 9,870. The cash balance at the end of June is forecasted to be RM 1,235.

Required: Prepare a cash budget for each of the months July to September.

Solution: Fatin Bhd. Cash Budget for July to September 2005 July RM Receipts: 10% in cash 90% in one month Total receipts Payments: Material purchases (one month credit) Direct wages Production overheads Selling, distribution & administration overhead Delivery vehicles Total payments Net cash inflow/(outflows) Opening cash balance Closing cash balance at the end of the month 1,360 11,250 12,610 3,450 1,300 2,900 1,700 9,350 3,260 1,235 4,495 August RM 1,700 12,240 13,940 3,780 1,300 2,900 1,700 9,870 19,550 (5,610) 4,495 (1,115) Sept. RM 1,680 15,300 16,980 2,890 1,300 2,900 1,700 8,790 8,190 (1,115) 7,075

Notice: In the month of August, BIB Bhd. will have a negative cash balance. This indicates that the company will need to borrow that amount (RM 1,115) to pay for the expenses in August According to the above cash budget, this amount can be repaid in September from the total receipts and no further loan would be required for the quarter. Illustration 4 The following data and estimates are available for Julia Limited for June, July and August. June July August (RM) (RM) (RM) Sales 45,000 50,000 60,000 Wages 12,000 13,000 14,500 Overheads 8,500 9,500 9,000 The following information is available regarding direct materials: June July August Sept (RM) (RM) (RM) Opening stock 5,000 3,500 6,000 4,000 Material usage 8,000 9,000 10,000

(RM)

b)

Notes: a) 10% of sales are for cash, the balance is received the following month. The amount received in June for Mays sales is RM 29,500. Wages are paid in the month they are incurred. c) Overheads include RM 1,500 per month for depreciation. Overheads are settled the month following. RM 6,500 is to be paid in June for Mays overheads.

d) e) f)

Purchases of direct materials are paid for in the month purchased. The opening balance cash balance in June is RM 11,750. A tax bill of RM 25,000 is to be paid in July. Required: a) Calculate the amount of direct material purchases in each of the months of June, July and August. b) Prepare cash budgets for June, July and August. Solution June (RM) 3,500 8,000 11,500 5,000 6,500 July (RM) 6,000 9,000 15,000 3,500 11,500 August (RM) 4,000 10,000 14,000 6,000 8,000

a)

Closing stock Material usage Less: Opening stock Direct material purchases

b)

Cash Budget for June, July and August June (RM) Receipts Sales cash (10%) Credit 4,500 29,500 34,000 July (RM) 5,000 40,500 45,500 August (RM) 6,000 45,000 51,000

Payments Wages Overheads Direct materials Taxation

12,000 6,500 6,500 25,000 11,750 34,000 (25,000) 20,750

13,000 7,000 11,500 25,000 56,500 20,750 45,500 (56,500) 9,750

14,500 8,000 8,000 30,500 9,750 51,000 (30,500) 30,250

Opening balance Receipts Payments Closing balance

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FIXED AND FLEXIBLE BUDGET At the end of the budget period, comparison of the actual outcome with the budgeted outcome is usually made for control purposes. When the managers make this comparison, it is important to ensure that they are making a valid comparison. The use of flexible budget can help to ensure that actual that actual result is monitored against realistic targets. Fixed Budget A fixed budget is a budget which is designed to remain unchanged irrespective of the volume of output or turnover attained ICMA Terminology. Fixed budget is prepared because: - it is good for planning purposes - serves to define broad objectives of the organization - it is single budget with no analysis of cost - it is a traditional budget If the costs being budgeted are fixed, then this causes no difficulty because irrespective of the level of the activity the expected costs are the same. However, if the costs are variable and the actual level of activity differs from that budgeted, the comparison between budget figures and actual outcomes does not have any meaning. Flexible Budget CIMA Terminology defines a flexible budget as a budget which by recognizing different cost behaviour patterns, is designed to change as volume of output changes. Essentially, budget is designed to adjust the permitted cost levels to suit the level of activity actually attained and is done for the following reasons: i) to monitor and control the activities during the budget period. ii) to help managers deal with certainly by allowing them to see the expected outcomes for a range of activity. ASPECTS OF HUMAN BEHAVIOR IN BUDGETING PROCESS The behavioural aspect of budgeting is to motivate people in achieving the budgets and a higher level of objectives. Specifically, in the designed and operations of budgetary control are: i) Goal Congruence ii) Participation iii) Motivation iv) Goal definition v) Communication Further explanation on each point will be discovered in the following paragraphs: i) Goal Congruence A very ideal budgeting system is the one that promote goal congruence where the goal individuals and groups should coincide with the goals and objectives of the organization as a whole. Although it is difficult to achieve completely, but at least recognition must be

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given to the fact that organizational objectives cannot be imposed through the budgeting system without consideration of the influences of local group and departmental objectives. ii) Participation All responsible people including employees should participate in setting the budget as it has been generally recognized that staff are better motivated to achieve goals if they participate in the setting of such goals. Motivation The whole process of budget preparation and performance evaluation accordingly, is required to be carried out in order to motivate managers. If the process is designed to be participative, encourage initiative and responsibility and it is not seen merely as a pressure device, then the motivation of individuals or groups will be encouraged. Goal definition It has been proven by research in human behavioural that people will work more efficiently and effectively when they have clearly defined targets and objectives. In the process of operating the budget system, the people concerned should clearly explain the budget and the companys objectives to the relevant employees during the budget period. Then, they will inform the importance of their roles and how the system is designed to help them achieve individuals target and the companys objectives as a whole. Communication The communication process is very essential between the layers and also across the layers in an organization in all planning and controlling systems. If the people who responsible to operate the budget but do not really understand the budgetary control system they may not accept it. Finally, it is impossible for management to have a realistic planning and control decisions.

iii)

iv)

v)

Problems in budgeting Due to human behaviour in relation to budgeting, below are some problems associated with budgeting: i) ii) iii) iv) v) There are may be too much reliance on the technique as a substitute to good management. Variances are just as frequently due to changing circumstances poor forecasting or general uncertainties as due to managerial performance. There is a major problem in setting the level of attainment to be included in budgets and standards. The inherent lags and delays in the system. Budget slack i.e. padding the budget. This is where revenue is underestimated or costs are overestimated. The difference between the revenue or cost projection that a person provides and a realistic estimate of the revenue or cost are called budgetary slack.

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For example: When a supervisor provides a departmental cost projection for budgetary purposes, there is a tendency to overestimate costs. When the actual cost incurred in the department proves to be less than the inflated cost projection, the supervisor appears to have managed in a cost-effective way. Let us take another example, if a plant manager believes the annual utilities cost will be RM 18,000, but gives a budgetary projection of RM 2,000 of slack into the budget. Self-Test Questions 1. 2.
3.

What is budget? Explain the meaning of budgeting control? State FIVE (5) reasons of preparing budget. Identify problems associating in budgeting. Discuss FIVE (5) aspects of human behavioural in budgeting. Distinguish between Flexible Budget and Master Budget. List down the functions of cash budget. Give FIVE (5) functions of cash budget. 9. 10. Why do we have to prepare a fixed budget and flexible budget respectively? Explain the steps in budgeting process.

4.
5.

6. 7.
8.

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11.

The Resak Company, a merchandising firm, has planned the following sales for the next four months: Total budgeted sales (RM) March 50,000 April 70,000 May 90,000 Jun 60,000

Sales are made 40 percent for cash and 60 percent on account. From experience, the company has learned that a months sales on account are collected according to the following pattern: Month of sale First month following month of sale Second month following month of sale Uncollectible 70% 20% 8% 2%

The company requires a minimum cash balance of RM 4,000 to start a month. Assume the following budgeted data for June:

RM Purchases Selling and administrative expenses Depreciation Equipment purchases Cash balance, beginning of June Required: a.Compute the budgeted cash receipts for June. b. Prepare a cash budget in good form for June. Clearly show any borrowing needed during the month. The company can borrow in any amount, but will not pay any interest until the following month. 52,000 10,000 8,000 15,000 6,000

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12.

The following forecasts are available from the present budgets being prepared by Kedai Sasi Bhd: March April May RM '000 RM '000 RM '000 440 280 640 420 133 140 77 75 June RM '000 160 150 124 70

Purchases Sales Salaries Overhead expenses

560 160 119 84

Other information is available as follows: i. 10% of all sales are made on a cash basis, the remainder being sold to customers who pay in the month following sale. ii. All goods are bought on credit from suppliers who allow 2.5% cash discount for payment in the month following purchase. iii. Salaries and wages are paid in the month in which they are earned. iv. Overhead expenses include depreciation amounting to RM 12,000 each month. Payments are made in the month following the month in which expenses are incurred. v. A dividend amounting to RM 88,000 will be paid in May. vi. A delivery van is to be sold for RM 3,000 cash in June. vii. The balance at the bank on 1 April is expected to be RM 90,000. Required: a) Construct a monthly cash budget in columnar form for the three months ending 30 June showing the bank balance at each month end. 13. Following are the information relating to JJ Bhd. for the four months ending September 2005. Cash at bank on 1st August 2005 RM 25,000 Monthly salaries and wages (estimated) RM 10,000 Interest payable in September 2006 RM 5,000 Estimated Cash sales Credit sales Purchases Other expenses July RM 120,000 100,000 160,000 18,000 Aug RM 140,000 80,000 170,000 20,000 Sept RM 152,000 140,000 240,000 22,000 Oct RM 121,000 120,000 180,000 21,000

Credit sales are collected 50% in the month of sale and 50% in the following month. Collections from credit sales are subject to 10% discount if received in the month of sale and to 5% discount is received in the following month. 10% of the purchases are in cash and balance is paid in next month. Required: Prepare a cash budget for three months ending October 2005. b) What are the advantages and disadvantages of budgeting?

a)

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14.

Following are the information relating to BJ Bhd for the four months ending September 2005. Cash at bank on 1st July 2005 Monthly salaries and wages (estimated) Interest payable in August 2006 Estimated Cash sales Credit sales Purchases Other expenses June RM 120,000 100,000 160,000 18,000 RM25,000 RM10,000 RM5,000 July RM 140,000 80,000 170,000 20,000 August RM 152,000 140,000 240,000 22,000 September RM 121,000 120,000 180,000 21,000

Credit sales are collected 50% in the month of sale and 50% in the following month. Collections from credit sales are subject to 10% discount if received in the month of sale and to 5% discount if received in the following month. 10% of the purchases are in cash and balance is paid in next month. Required:
a)

b) 15.

Prepare a cash budget for three months ending September 2005. What are the advantages and disadvantages of budgeting?

Bucket and Spade Bhd. manufacture plastic sandplay items for children and the selling price per item is RM 100. Market research indicates that sales for the five months ending August 2006 will be: April 80,000 May 120,000 June 160,000 July 120,000 August 80,000

The following information also applies. i) A 10% under-estimate of demand is to be allowed for.

ii) It is hoped that an advertising campaign beginning in March will add a further 20% to each months sales, based on the original figures. iii) A fall in unemployment is expected to lead to an increase in beach holidays and this will result in a 2% increase in demand (based on the original figures) for all products from June. iv) The strength of the RM against other currencies has resulted in an increase in the demand for foreign holidays. This is expected to boost unit sales by 4,000 in May; 8,000 in June; 10,000 in July; and 5,000 in August. Required: a) Prepare a sales budget for the period April to August 2006.

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