p1 ch11 the budgeting framework - practice tests academy · 2018. 11. 2. · p1 – management...

P1 – Management Accounting CH11 – The budgeting framework

Chapter 11 The budgeting framework Chapter learning objectives:

Lead Component Indicative syllabus content

B1 Explain the purposes of forecasts, plans and budgets.

(a) Explain the purposes of budgets, including planning, communication, coordination, motivation, authorisation, control and evaluation and how these may conflict.

• The role of forecasts and plans in resource allocation, performance evaluation and control.

• The purposes of budgets, the budgeting process and conflicts that can arise.

B3 Discuss budgets based on forecasts.

(a) Prepare a budget for any account in the master budget based on projections/forecasts and managerial targets.

• The budget setting process, limiting factors, and the interaction between component budgets and the master budget.

(b) Discuss alternative approaches to budgeting.

• Alternative approaches to budget creation, including incremental approaches, zero-based budgeting and activity-based budgets.

B5 Analyse performance using budgets, recognising alternative approaches and sensitivity to variable factors.

(a) Analyse the consequences of ‘what if’ scenarios.

• ‘What if’ analysis based on alternative projections of volumes, prices and cost structures.

• The evaluation of out-turn performance using variances based on ‘fixed’ and ‘flexed’ budgets.


1. Budget • A quantitative or financial plan that relates to future.

• Prepared for a department, function or product.

• Can also be prepared for resources such as cash, material or labour.

• Usually for one year, can also be quarterly or semi-annual.

Test Your Understanding 1 – Budget periods Each budget period is normally split into control periods known as:

A. Budget intervals

B. Review periods

C. Financial periods

D. None of the above

2. Purpose of budgeting

Planning • A budget compels planning.

• It forces an entity’s management to look ahead, set targets and anticipate problems.

• It gives an organisation purpose and direction.

Purposes of budget

Planning

Control & evaluation

Co-ordination

Communication

Motivation

Authorisation


Control and evaluation • The budget provides a plan against which actual results can be measured.

• Results that are out of line with the budget can be investigated and corrected.

• A manager’s performance can be assessed on the basis of his/her success in achieving the given budget.

Coordination • The budget coordinates the actions of different parts of the organisation and reconciles

these with a common plan.

• A sound budgeting system helps to coordinate the different activities of a business and ensure that these are in harmony.

Communication • A budget communicates targets to managers.

• A budget helps the top management to deliver its expectations to the lower-level management.

• A budget helps ensure that all of the members of the organisation understand the expectations and can coordinate their activities to attain them.

Motivation • A budget is a useful device for influencing managerial behaviour.

• It motivates managers to perform in line with the organisational objectives.

Authorisation • A budget acts as formal authorisation to a manager for expenditure.

• A budget also authorises the manager to hire the staff and pursue the plans contained in the budget.

Budget period • The time frame for which the budget is prepared.

• This is typically 1 year, which reflects the fact that the financial statements for most organisations cover a 1-year period.

• A budget can be of any length of time that suits the purposes of management.


Budget interval • Budgets are split into CONTROL PERIODS known as BUDGET INTERVALS.

• The budget interval is normally 3 months or 1 month.

• A 1-year budget is split into component parts for each budget interval.

• A budgetary control report is prepared at the end of each interval in which the budget and actual results are compared.

3. Master budget and functional budgets

Key requirements for the budgetary planning and control process Budget committee

• A budget committee is set up to achieve coordination in the planning process.

• The committee comprises representatives from all functions in the organisation.

• It should meet regularly to review the progress of the budgetary planning process and to resolve problems.

The budget manual

• A collection of documents containing key information for those involved in the planning process.

• Effective budgetary planning relies upon adequate information appearing in the budget manual.


Principal budget factor or limiting budget factor • When a key resource is in short supply and affects the planning decision, it is known as

the principal budget factor or limiting budget factor.

• Sales demand will be the key factor setting a limit on what the organisation can expect to achieve in the budget period.

• Determination of the principal budget factor should be the starting point for all other budgets.

• There may be other limiting factors such as material, labour and cash.


Budget preparation Step 1: The sales budget states how many units are to be sold.

Step 2: The production budget states how many units will be produced to meet the sales level.

The difference between the production budget and sales budget is the inventory of finished goods.

Step 3: Material, labour and overhead budgets can be established based on the production budget.

Step 4: Non-production budgets should also be considered.

Steps 5, 6 & 7: The master budget is prepared, comprising the statement of profit or loss, statement of financial position and cash budget.

Test Your Understanding 2 – Budget factors Which of the following best represents the principal budget factor?

A. A key resource in short supply that affects a decision.

B. A key resource in short supply but not affecting a decision.

C. A resource that is not scarce but affects a decision.

D. A resource that causes slack.

Types of budgets Sales budget:

• Budget for future sales in terms of sales revenue

• Budget for sales units

• Could be for the whole organisation or for different sales regions

Production budget:

• Follows on from the sales budget, as production quantities are determined from the sales volume

• Production volume differs from sales volume by the amount of any planned increase or decrease in inventories of finished goods and work in progress


Direct material usage budget:

• The budget for quantities and costs for the material required for the planned production.

Material purchase budget:

• The budget for the cost of materials to be purchased in a period.

• The purchase cost of the direct material will differ from the material usage budget if there is a planned increase or decrease in direct material inventory.

• The purchase budget should also account for indirect material purchase cost.

Direct labour budget:

• Accounts for direct labour cost for production.

• A variable direct labour cost is calculated by multiplying the production quantities in units by the budgeted direct labour cost per unit.

• If the labour cost is fixed, it can be determined by calculating the payroll cost.

Production overheads:

• When absorption costing is used, overheads are allocated and apportioned.

• Budgeted overhead absorption rates are determined.

Administration and sales and distribution overheads:

• Other overhead costs should also be budgeted.

Budgeted statement of profit or loss account and balance sheet

• After preparing the sales and costs budgets, a “Master Budget” can be summarised as a statement of profit or loss for the period, a cash budget and a balance sheet at the end of each budget period.

Sales budget

Direct material usage budget

Material purchase budget

Direct labour budget

Production overheads

Production budget


Test Your Understanding 3 – Master budget Which of the following comprises the master budget?

A. Capital expenditure budget, cash budget and sales budget.

B. Budgeted statement of profit or loss, cash budget and budgeted statement of financial position.

C. Sales budget, cash budget and production budget.

D. Sales budget, capital expenditure budget and budgeted statement of profit or loss.

Cash budget and cash flow forecast A cash flow forecast is an estimate of the cash receipts and payments for a future period under the existing conditions.

Cash budget:

The commitment to a plan for cash receipts and payments for a future period after taking any action necessary to bring the forecast in line with the overall business plan.

Uses of a cash budget:

• Assess and integrate operational budgets.

• Plan for cash shortage and surplus.

• For comparison with actual spending.

Receipts and payments forecast:

The forecast of receipts and payments is based on predictions for sales and cost of sales and timing of cash flows relating to those items.

Preparing forecasts from planned receipts and payments:

• Each type of cash inflow and receipt, along with their timing, must be forecast.

• Cash receipts and payments differ from sales and cost of sales because:

o Not all cash receipts and payments affect the statement of profit or loss account.

o Some profit or loss account items are derived from accounting conventions and are not cash flows, such as depreciation or gain or loss on the disposal of assets.

o The timing of cash receipts and payments does not coincide with the timing of the accounting period for which the profit or loss account is prepared.


o Irrecoverable debts will never be received in cash, and an allowance for receivables may not be received at all.

Note: When forecasting cash receipts from customers, remember to adjust for these items.

Test Your Understanding 4 – Forecasting cash receipts The forecast sales for an organisation are as follows:

January February March April

Sales ($) 5,000 8,000 4,000 6,000

All sales are on credit, and receivables tend to be paid in the following pattern:

%

In the month of the sale 10

In the month after the sale 40

Two months after the sale 45

The organisation expects the rate of irrecoverable debts to be 5%.

Calculate the forecast for cash receipts from receivables in April __________

Interpretation of a cash budget:

The following factors to be considered when interpreting the cash budget.

• Does the balance at the end of the period match that expected?

• Does the cash balance go into deficit at any time in the period?

• If so, are there sufficient funds available to cover the cash deficit?

• What are the key causes of any deficits?

• Can discretionary expenditures be made in any other period to stabilise the cash pattern?

• Is there any plan for dealing with a cash surplus?


4. Sensitivity analysis • An approach to reporting a significant degree of uncertainty concerning many of the

elements incorporated within a business plan or budget.

• A sensitivity analysis exercise involves revising the budget based changes to one variable (one assumption can be changed at a time).

• That is why we use spreadsheets to facilitate this analysis.

5. Periodic vs rolling budgets • A periodic budget is a budget that shows the cost and revenue for one period of time,

e.g. 1 year, and is updated periodically, e.g. every 12 months.

• A rolling budget/continuous budget is continuously updated by adding a further accounting period when the earlier accounting period has expired. Rolling budgets are for a fixed period, but this need not be a full year.

Reasons for using a rolling budget • It is prepared to deal with uncertainty in the budget.

• It is prepared to induce accuracy and reliability in the budget.

Advantages of rolling budgets Disadvantages of rolling budgets

Reduce uncertainty in budgeting Preparing a new budget is time-consuming

Used for cash management It is difficult to communicate the frequent budget changes

Force managers to look ahead more continuously

When conditions are subject to change, comparing actual results with a rolling budget gives a more realistic view than comparing actual results with a fixed annual budget

Test Your Understanding 5 – Rolling budgets Which TWO of the following are advantages of rolling budgets?

A. They force managers to look ahead continuously.

B. They compare actual results with a fixed annual budget.

C. They can be used for cash management.

D. It is easier to communicate frequent budget changes.


Budget styles • Top-down (non-participatory) – created and executed by senior management. The

targets set are communicated to various departmental managers and imposed on the organisation.

• Bottom-up (participatory) – shares decision making and control across the organisation. Middle managers and other key staff are invited to discuss and plan targets before they are set. This consultation process can result in more realistic budgets as well as improving the morale of the staff involved.

6. Alternative approaches to budgeting

Incremental budgeting • Incremental budgeting is prepared using a previous budget or actual performance as a

basis, with incremental amounts added for the new budget (e.g. inflation).

Advantages of incremental budgets Disadvantages of incremental budgets

• They are stable, and change is gradual

• They help managers to operate their departments on a consistent basis

• The system is simple and easy to operate

• They make it easier to achieve coordination

• The impact of change can be seen quickly

• No incentive to reduce cost and bring up ideas

• Assume work and activities will continue in the same way

• Encourage spending up to the budget so that the budget is maintained in the next year

• The budget may become out of date and no longer relate to the level of activity or type of work being carried out

Test Your Understanding 6 – Incremental budgeting Which of the following is a disadvantage of incremental budgeting?

A. Targets are difficult to achieve

B. Encourages over-spending

C. Not suitable for stable environments

D. Expensive to implement


Zero-based budgeting (ZBB) ZBB may be defined as “the method of budgeting whereby all activities are re-evaluated each time a budget is formulated. Each functional budget starts with the assumption that the function does not exist and is at a zero cost. The increments of costs are compared with the increments of benefits, culminating in the planned maximum benefit for a given budgeted cost.”

• With zero-based budgeting, we start from scratch. We consider each activity on its own merits and draw up the costs and benefits of the different methods of achieving it (and indeed whether or not the activity should continue). The management then decides on the most effective way of performing each activity.

• ZBB is bottom-up by nature and aims to cut wasteful expenditure.


Advantages of ZBB Disadvantages of ZBB

• Creates an environment that accepts change

• Better focus on goals

• Is forward-looking

• Improves resource utilisation

• Provides better performance measures

• Pushes managers to examine the activities

• Time-consuming and expensive

• Encourages short-termism

• Managers may lose focus on true cost drivers

• Managers may need new budgeting skills

• Such budgets may result in arbitrary decisions

Activity-based budgeting “An approach to budgeting based on an activity framework and utilising cost driver data in the budget setting and variance feedback process.”

• Zero-based budgeting is based on budgets prepared by responsibility centre managers, whereas, “activity-based budgeting” is based on budgeting for activities.

• The activity-based approach uses the principles and costing information obtained by an ABC costing system.

• The basic ABB approach to budget the costs for each cost pool or activity is as follows:

1) Identify the cost driver for each activity.

2) Make a forecast for the number of units of the cost driver that will occur in the budget period.

3) Given the estimate of the activity level for the cost driver, estimate the activity cost.

4) Where appropriate, calculate a cost per unit of the activity, known as the cost driver rate.

Advantages of ABB Disadvantages of ABB

• Useful when overheads are significant

• Better cost control

• Provides better information for management

• Appropriate for TQM environments

• Expensive to implement

• Only useful for ABC users as the standard costing system


Test Your Understanding 7 – ABB Which of the following is an advantage of activity-based budgeting?

A. Only suited to ABC users

B. Useful for a TQM environment

C. Cheap to implement

D. Useful when there are insignificant overheads

7. Solutions to Test Your Understanding

Test Your Understanding 1 – Budget periods Correct option: A

Each budget period is normally split into control periods known as budget intervals.

Test Your Understanding 2 – Budget factors Correct option: A

A key resource in short supply that affects a decision is known as the principal budget factor.

Test Your Understanding 3 – Master budget Correct option: B

The master budget comprises the budgeted statement of profit or loss, cash budget and budgeted statement of financial position.

Test Your Understanding 4 – Forecasting cash receipts Cash from April sales: $5,800

Working:

$

April sales $6,000 × 10% 600

March sales $4,000 × 40% 1,600

February sales $8,000 × 45% 3,600

Total cash receipts in April 5,800


Test Your Understanding 5 – Rolling budgets Correct options: A & C

The following are the advantages of rolling budgets:

• They force managers to look ahead continuously.

• They can be used for cash management.

Test Your Understanding 6 – Incremental budgeting Correct option: B

A disadvantage of incremental budgeting is that it encourages overspending.

Test Your Understanding 7 – ABB Correct option: B

Activity-based budgeting has the advantage that it is useful for a TQM environment.

8. Chapter Summary

p1 ch11 the budgeting framework - practice tests academy · 2018. 11. 2. · p1 – management...

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