CHAPTER 06

BUDGETING

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 LEARNING OBJECTIVES

• Apply forecasting techniques to assist

management in performance measurement and
planning.
• Identify how data analytics can be used in
budgeting and forecasting.
• Prepare budgets, or extracts therefrom, from
information supplied.
• Select the most appropriate of the following
budgeting approaches and methods, taking into
account their advantages and disadvantages for
planning, control and motivation
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 CHAPTER CONTENT

6.1. Why do organizations prepare budgets?

6.2. A framework for budgeting
6.3. Steps in the preparation of a budget.
6.4. The master budget
6.5. Preparing forecasts
6.6. Alternative approaches to budgeting

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 6.1. Why do organizations
prepare budget?
6.1.1 Reasons for preparing budgets

• An organization’s budget fulfills many roles.

• Some of reasons why the budgets are used:

 compel planning,
 communicate ideas and plans,
 coordinate activities,
 means of allocating resources,
 authorization,
 provide a framework for responsibility accounting,
 establish a system of control,
 provide a means of performance evaluation,
 motivate their employees to improve their performance.
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 6.1. Why do organizations
prepare budget?
6.1.2 Budgets vs. forecasts

Forecast Budget
A prediction of what is likely A quantified plan of what the
to happen in the future organization intends should
happen in the future.
No control can be exercised Budget forces management
into decision-making and
taking action.
Budget is based on the
forecast.

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 6.1. Why do organizations
prepare budget?
6.1.3 Quantified budgets

- To fulfill the range of purposes for which it is prepared, a

budget must be quantified, but not necessarily only in
financial terms.

- Budgets provide definite plans, as well as yardsticks for

control purposes.

- Time bound is an important feature of any quantified

budget.

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 6.1. Why do organizations
prepare budget?
6.1.3 Quantified budgets

- Given these statements, which is particularly useful for

planning and control purposes:

(1) ‘We plan to utilize fully all the available hours of semi-
skilled labor next period.’
(2) ‘We plan to minimize expenditure on advertising next
period.’
(3) ‘We plan to utilize 24,800 hours of semi-skilled labor next
period.’
(4) ‘We plan to spend £107,000 on advertising next period.’

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 6.2. A framework for budgeting

6.2.1 Budget Committee

- Budget committee is the coordinating body in the

preparation and administration of budgets.

- Budget committee is usually headed up by the managing

director (as chairman) who is assisted by a budget officer
(e.g. finance director, accountant…)

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 6.2. A framework for budgeting
6.2.1 Budget Committee

Functions of the budget committee are as follow:

 Coordination and allocation of responsibility for preparing

budgets
 Issuing of the budget manual
 Timetabling
 Provision of information to assist in preparing budgets.
 Communication of final budgets to appropriate managers
 Monitoring the budgeting process by comparing actual
and budgeted results.

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 6.2. A framework for budgeting
6.2.2 The budget period

- The budget period is the period covered by the budget,

usually one year.

- Budgets are divided into a number of control period,

typically calendar months.

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 6.2. A framework for budgeting
6.2.2 The budget period

Can budgets be prepared for long-

term period?

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 6.2. A framework for budgeting
6.2.2 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.

- Including these followings:

 An explanation of the objectives
 Organizational structures
 Principal budgets and the relationship between them
 Administrative details
 Procedural matters

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 6.3. Steps in the preparation of
a budget
6.3.1 Identifying the principal budget factor

- The budget for principal budget factor must be prepared

first.

- Principal budget factor is that factor which limits an

organization’s activities.

- This factor is usually sales demand.

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 6.3. Steps in the preparation of
a budget
6.3.1 Identifying the principal budget factor

Why is sales demand the principal

budget factor?

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 6.3. Steps in the preparation of
a budget
6.3.2 The order of budget preparation

* See next page for information

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 6.3. Steps in the preparation of
a budget
6.3.3 Preparing functional budgets
- Functional/department budgets includes budgets for
sales, production, purchases, labor and administration.
- Work example: Preparing a materials purchases budget
* Next page

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 6.3. Steps in the preparation of
a budget
*Work example: Continued
Product S Product T
Budgeted Sales (units) 8,000 units 6,000 units
Raw materials Material D Material E
Product S 3 liters 4 kilograms
Product T 5 liters 2 kilograms
Expected cost £3/liter £7/kg
Finished goods in stock
Closing stock (units) 600 600
Opening stock (units) 1,500 300
Raw material in stock Material D Material E
Closing stock 5,000 liters 3,500 kilograms
Opening
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201112-BUDGETING liters 2,800 kilograms
18
 6.3. Steps in the preparation of
a budget
*Work example: Continued
A provision should be made for damages and deterioration
of items held in store, as follows.
Product S : loss of 50 units
Product T : loss of 100 units
Material D : loss of 500 liters
Material E : loss of 200 kilograms
Requirement
Prepare a material purchases budget for the year 20X2
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 6.3. Steps in the preparation of
a budget
6.3.2 Preparing functional budgets
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
Production required
To meet sales demand 8,000 6,000
To provide for inventory loss 50 100
For remaining closing inventory 600 600
Less opening inventory (1,500) (300)
Budgeted production volume 7,150 6,400

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 6.3. Steps in the preparation of
a budget
6.3.2 Preparing functional budgets
Material purchases budget
Material D (Liters) Material E (Kg)
To produce 7,150 units of S 21,450 28,600
(7,150 units x 3 liters/unit) (7,150 units x 4 kg/units)
To produce 6,400 units of T 32,000 12,800
To provide for inventory loss 500 200
For remaining closing inventory 5,000 3,500
Less opening inventory (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 purchase £454,950 (= 158,850 + 296,100)

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 6.3. Steps in the preparation of
a budget
6.3.4 The link between budgeting and standard costing

 The information about expected price and usage of

resources is provided by a standard costing system.
 A standard cost is a predetermined unit cost that details
the price and quantity of resources (material, labour and
so on) required for each unit of product or service.
 The detailed standard cost also enables control to be
exercised over actual performance.

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 6.4. The master budget
6.4.1. The content of the master budget

- Providing a consolidation of all the subsidiary budgets

and normally comprises a budgeted income statement,
a budgeted balance sheet and a cash budget.
- Work example: Preparing a budgeted income statement
and balance sheet
* Next page

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 6.4. The master budget
6.4.1. The content of the master budget (continued)
* Worked example: Continued
Use the following information to prepare a budgeted income
statement for the six months ended 30 June and a budgeted
balance sheet at that date.
 Non-current assets will be purchased for £12,000. A straight line
basis depreciation, a useful life of five years, no residual value.
 Month-end inventories will be maintained at a level sufficient to
meet the forecast sales for the following month.

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 6.4. The master budget
6.4.1. The content of the master budget (continued)
* Worked example: Continued
 The gross profit margin is budgeted to be 20% of sales value.
 Two months’ credit will be allowed to customers and one month’s
credit will be received from suppliers of inventory.
 Operating expenses (excluding depreciation) are budgeted to be
£350 each month.
 The budgeted closing cash balance as at 30 June is £16,700.
 Forecast monthly sales are £4,000 for January to March, £5,000
for April to June and £6,000 per month for July onwards.

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 6.4. The master budget
6.4.1. The content of the master budget (continued)
* Solution:
Budgeted income statement for 6 months ended 30 June
£ £
Revenue ((£4,000 x 3) + (£5,000 x 3)) 27,000
COGS (£27,000 x 80/100) 21,600
Gross profit 5,400
Operating expense (£350 x 6) 2,100
Depreciation ((£12,000/5) x 6/12) 1,200
3,300
Budgeted profit 2,100

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 6.4. The master budget
6.4.1. The content of the master budget (continued)
Budgeted balance sheet as at 30 June
£ £
Non-current assets (£12,000 - £1,200 depreciation) 10,800
Current assets
Inventories (July cost of sales = £6,000 x 80/100) 4800
Receivables (May & June sales) 10,000
Cash 16,700
31,500
Current liabilities
Trade payables (June purchases = July COGS) 4,800
Net current assets 26,700
37,500
Owner’s capital 37,500
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 6.4. The master budget
6.4.2. Performing a sensitivity analysis
 Of particular interest to senior managers will be the
sensitivity of the budget outcomes to changes in the
budget assumptions.
 A sensitivity analysis (sometimes called a ‘what if?’
analysis) might be performed to show the effect of
changes such as these, and to assess the impact on
critical areas such as cash resources.

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 6.5. Preparing forecasts
6.5.1. Forecasting using historical data

 Numerous techniques have been developed for using

past costs as the basis for forecasting future values.
 These techniques range from simple arithmetic to
advanced computer-based statistical systems.
 With all these techniques the important presumption is
made that the past will provide guidance to the future.

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 6.5. Preparing forecasts
6.5.2. Linear Relationships

A linear relationship can be expressed in the form of an

equation that has the general form y = a + bx, where

 y is the dependent variable, depending for its value on the

value of x
 x is the independent variable, whose value helps to
determine the corresponding value of y
 a is a constant, a fixed amount
 b is a constant, being the coefficient of x (that is, the number
by which the value of x should be multiplied to derive the
value of y)

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 6.5. Preparing forecasts
6.5.3. The high-low method

Step 1:
ie the high/low
The period with the highest volume of activity values of the
The period with the lowest volume of activity independent
variable
Step 2:
The variable cost per unit may be calculated from this as
(difference in total costs / difference in activity levels).

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 6.5. Preparing forecasts
6.5.3. The high-low method (continued)

Step 3:
The fixed cost may then be determined by substitution.

Step 4:
The linear equation y = a + bx can be used to predict the cost
for a given activity level.

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 6.5. Preparing forecasts
6.5.3. The high-low method (continued)
Example:
The costs of operating the maintenance department of a computer
manufacturer, Bread and Butter Ltd, for the last four months have been
as follows. Month Cost Production Volume
£ Units
1 110,000 7,000
2 115,000 8,000
3 111,000 7,700
4 97,000 6,000
Requirement
Calculate the costs that should be expected in month 5 when output is expected to
be 7,500 units. Ignore inflation.
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 6.5. Preparing forecasts
6.5.3. The high-low method
Solution:

Step 1:
Units £
High output 8,000 total cost 115,000
Low output 6,000 total cost 97,000
Total variable cost 2,000 18,000
Step 2:
Variable cost per unit £18,000/2,000 = £9

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 6.5. Preparing forecasts
6.5.3. The high-low method
Solution:
Step 3:
Substituting in either the high or low volume cost:
High Low
£ £
Total cost 115,000 97,000
Variable cost (8,000 x £9) 72,000 (6,000 x £9) 54,000

Fixed cost 43,000 43,000

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 6.5. Preparing forecasts
6.5.3. The high-low method
Solution:
Step 4:
Estimated maintenance costs when output is 7,500 units:

£
Fixed cost 43,000
Variable cost (7,500 x £9) 67,500
Total costs 110,500

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 6.5. Preparing forecasts

6.5.4. Linear Regression Analysis

 Linear regression analysis is superior to the high-low

method because it takes account of all sets of recorded
data.
 A further issue with the use of both the high-low method
and linear regression analysis is that the quality or
reliability of the linear equation derived will depend upon
the correlation between the variables.

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 6.5. Preparing forecasts
6.5.5. Correlation
Correlation is the degree to which one variable is related to
another, ie the degree of interdependence between the
variables.

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 6.5. Preparing forecasts

a. Degree of correlation

Two variables might be perfectly correlated, partly

correlated, uncorrelated or subject to non-linear
correlation.

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 6.5. Preparing forecasts
a. Degree of correlation (continued)

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 6.5. Preparing forecasts
a. Degree of correlation (continued)

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 6.5. Preparing forecasts
a. Degree of correlation (continued)

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 6.5. Preparing forecasts
a. Degree of correlation (continued)

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 6.5. Preparing forecasts
b. Positive and negative correlation
 Positive correlation is the type of correlation where low
values of one variable are associated with low values of
the other, and high values of one variable are associated
with high values of the other.
 Negative correlation is the type of correlation where low
values of one variable are associated with high values of
the other, and high values of one variable are associated
with low values of the other.
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 6.5. Preparing forecasts
6.5.6 Measures of correlation

a. The coefficient of correlation, r

 The degree of correlation between two variables can be
measured using the coefficient of correlation, r.
 r has a value between –1 (perfect negative correlation)
and +1 (perfect positive correlation). If r = 0 then the
variables are uncorrelated.

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 6.5. Preparing forecasts
6.5.6 Measures of correlation

b. The coefficient of correlation, r2

 The coefficient of determination, r2, is a measure of the
proportion of the change in one variable that
can be explained by variations in the value of the other
variable.

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 6.5. Preparing forecasts
6.5.7 Big data, data analytics and data mining

a. Big data – What is it?

 Definition: datasets whose size is beyond the ability of
typical database software to capture, store, manage and
analyse
 Main characteristics: volume, variety and veracity

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 6.5. Preparing forecasts
6.5.7 Big data, data analytics and data mining (continued)

b. Big data benefits:

 Forecasting demand: contribute to generate an accurate
model of future demand, which further help predict
customer demand responses to new products and
marketing campaigns.
 Identifying customer preperences

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 6.5. Preparing forecasts
6.5.7 Big data, data analytics and data mining (continued)

c. Big data problems:

 Lack of forecasting tools
 Privacy
 Security
 Incorrect data
 Lack of skilled data analysts

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 6.6. Alternative approach to
budgeting
6.6.1 Participation in budgeting process

There are basically two ways in which a budget can be set:

from the top down (imposed budget) or from the bottom up
(participatory budget).

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 6.6. Alternative approach to
budgeting
a. Imposed or top-down style of budgeting
Top management prepare a budget with little or no input from
operating personnel, which is then imposed upon the
employees who have to work to the budgeted figures
 In newly-formed organisations
 In very small businesses
 During periods of economic hardship
 When operational managers lack budgeting skills
 When the organisation’s different units require precise
coordination
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 6.6. Alternative approach to
budgeting
a. Imposed or top-down style of budgeting (continued)
Advantages:
- Strategic plans are likely to be incorporated into planned
activities.
- Enhancing the coordination between plans and objectives of
divisions.
- Senior awareness of total resource availability.
- Decrease the input from inexperienced and uninformed lower-
level employees.
- Decrease the period of time taken to draw up the budgets.
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 6.6. Alternative approach to
budgeting
a. Imposed or top-down style of budgeting
Disadvantages:
- Dissatisfaction, defensiveness and low morale amongst
employees.
- The feeling of team spirit may disappear.
- The acceptance of organizational goals and objectives could be
limited.
- Budget may be viewed as a punitive device.

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 6.6. Alternative approach to
budgeting
a. Imposed or top-down style of budgeting (continued)
Disadvantages: (continued)
- Managers who are performing operations on a day to day
basis are likely to have a better understanding of what is
achievable.
- Unachievable budgets could result if consideration is not
given to local operating and political environments. This
applies particularly to overseas divisions.
- Lower-level management initiative may be stifled
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 6.6. Alternative approach to
budgeting
b. Participative or bottom-up style of budgeting

 Budgets are developed by lower-level managers who then

submit the budgets to their superiors.
 The budgets are based on the lower-level managers’
perceptions of what is achievable and the associated
necessary resources.

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 6.6. Alternative approach to
budgeting
b. Participative or bottom-up style of budgeting
Advantages:
- Based on information from the employees most familiar
with the department.
- Knowledge spread among several levels of management
is pulled together (ie information asymmetry is reduced).
- Morale and motivation is improved.
- Increase operational managers’ commitment to
organizational objectives.
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 6.6. Alternative approach to
budgeting
b. Participative or bottom-up style of budgeting (continued)

Advantages: (continued)
- More realistic.
- Co-ordination between units is improved.
- Specific resource requirements are included.
- Senior managers’ overview is mixed with operational level
details.
- Individual managers’ aspiration levels are more likely to
be taken into account

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 6.6. Alternative approach to
budgeting
b. Participative or bottom-up style of budgeting
Disadvantages:
- They consume more time.
- Changes implemented by senior management may cause
dissatisfaction.
- Budgets may be unachievable or much too soft if
managers are not qualified to participate.

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 6.6. Alternative approach to
budgeting
b. Participative or bottom-up style of budgeting
Disadvantages: (continued)
- They may cause managers to introduce budget slack
(overstating costs or understating revenues) and budget
bias.
- They can support ‘empire building’ by subordinates.
- An earlier start to the budgeting process could be
required.

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 6.6. Alternative approach to
budgeting
6.6.2 Incremental budgeting

Incremental budgeting is budgeting based on slight changes

from the preceding period's budgeted results or actual
results as it is concerned mainly with the increments in costs
and revenues which will occur in the coming period.

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 6.6. Alternative approach to
budgeting
6.6.2 Incremental budgeting (continued)

 It is a reasonable approach if the current operations are

as effective, efficient and economic.
 It is an inefficient form of budgeting. It encourages slack,
which is unnecessary expenditure built into the budgets.
Past inefficiencies are perpetuated because cost levels
are rarely subjected to close scrutiny.

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 6.6. Alternative approach to
budgeting
6.6.3 Zero-based budgeting

 Zero based budgeting (ZBB) is an approach to budgeting

that attempts to ensure that inefficiencies are not
concealed.
 Instead of using the current year’s results as a starting
point, each budget should be prepared from the very
beginning or zero.

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 6.6. Alternative approach to
budgeting
6.6.3 Zero-based budgeting (continued)

 Increments of expenditure are compared with the

expected benefits received, to ensure that resources are
allocated as efficiently as possible.
 ZBB can be particularly useful when applied to
discretionary costs such as marketing and training costs.
 A major of disadvantage of ZBB is that it is a time-
consuming task that involves a great deal of work.

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 6.6. Alternative approach to
budgeting
6.6.4 Rolling budgets

 Rolling budgets are sometimes called continuous

budgets. They are particularly useful when an
organisation is facing a period of uncertainty so that it is
difficult to prepare accurate plans and budgets.
 Preparing targets and plans that are more realistic and
certain.

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 6.6. Alternative approach to
budgeting
6.6.4 Rolling budgets (continued)

Advantages:
- Reduce the element of uncertainty in budgeting.
- Force managers to reassess the budget regularly.
- Planning and control will be based on a recent plan instead
of an annual budget that might have been prepared many
months ago and is no longer realistic.
- There is always a budget that extends for several months
ahead.
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 6.6. Alternative approach to
budgeting
6.6.4 Rolling budgets (continued)

Disadvantages:
- Involve more time, effort and money in budget
preparation.
- Frequent budgeting might have an off putting effect on
managers who doubt the value of preparing one budget
after another at regular intervals.

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 6.6. Alternative approach to
budgeting
6.6.5 Alternative budget structures
a. Product based budgets
 This structure is appropriate when the cost and revenue
responsibilities differ for each product, or when a single
manager is responsible for all aspects of one product.
 The separate product budgets and the possibility for
aggregation across products enables senior managers to
look both down and across the whole organization in terms
of budgets.
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 6.6. Alternative approach to
budgeting
6.6.5 Alternative budget structures
b. Responsibility based budgets
 Responsibility based budget systems segregate budgeted
revenues and costs into areas of personal responsibility in order
to monitor and assess the performance of each part of an
organization.
 An individual manager (a budget holder) will be responsible for
managing the budget center and ensuring that the budget is met.
 The budget holder is not held responsible for costs and revenues
over which they have no control.
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 6.6. Alternative approach to
budgeting
6.6.5 Alternative budget structures
c. Activity based budgets
 Activity based budgets are based on a framework of
activities, and cost drivers are used as a basis for preparing
budgets.
 The budget for each activity is derived from the quantity of
the activity’s cost driver x the appropriate cost driver rate.

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 QUESTION – ANSWER

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 QUESTION – ANSWER
Q1. 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
Q2. Which of the following is unlikely to be contained in a budget
manual?
A. Organisational structures
B. Objectives of the budgetary process
C. Selling overhead budget
D. Administrative details of budget preparation
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 QUESTION – ANSWER
Q3. Cassius Ltd manufactures two products, P and Q, from the same
material, S.
A finished unit of product P contains three litres of material S and a finished
unit of product Q contains five litres. However, there is a high wastage rate of
materials and 25 percent of the input materials are lost in production.
The budgeted production volumes for next year are 6,000 units of P and
8,100 units of Q. At the beginning of the year the company expects to have
20,000 litres of material S in inventory but intends to reduce inventory levels
to 5,000 litres by the end of the year.
The purchase cost of material S is £1.60 per litre.
The purchases budget for material S is:

A. £63,000
B. £93,000
C. £100,800
D. £148,800

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