Budgeting
A budget is a detailed plan, part of the company business plan outlining the acquisition and use of financial and other resources over some given time period, a plan expressed in formal quantitative terms
The planning process involves the development of future objectives and the preparation of various detailed budgets to achieve these objectives.
The control process involves the steps taken by management to ensure taht the objectives set down at the planning stage are attained.
To have a decision making process , you need to plan , to implement the plans where you direct and you motivate, you need to measure performance control and then in the end you need to evaluate the differences between plans and actual performance ( controlling)
Control , compare actual results vs planned results and calculate the differences
Management by exception
If variances are significant , investigate and take corrective action right, then focus on the areas that need attention
( actual – budget )/ budget >= 5 % then take corrective action
UBC has budgeted sales to occur evenly throughout the year at 1 million . The income statement for the quarter ended march 31 indicates 2.94 million in sales
Sales revenue actual : 2.97
Budjet : 3
Variance : – 0.03 M
Significant 2.97-3/3 = 1 percent , this means that it is not significant
Advantages of budgeting :
a) Planning top priority and provides managers to formalize planning efforts and thing about the future
b) Managers can communicate their plans in an orderly way throughout the organization
c) Coordination between departments
d) Evaluate performance and evaluate performance, however since you know that you will be evaluated, mangers play games such as padding the budget
e) Uncover potential bottlenecks before it occurs , cash shortage , labour shortage, machine capacity and such.
Responsability accounting
a) Each managers performance should be evaluated how he manages this items directly under his/ her control
b) Personalizes the accounting system , looking at cost from a personal control standpoint , rather than an institutional ( company ) standpoint.
Behavioural aspects of budgeting
The success of any budget program will be determined in large part by the way in which the budget itself is developed
Self imposed participative buget ( bottom up)
Advantages
a) Individuals are recognized as team members whose views and judgements are valued by top management . ( joint decision making )
b) The person in direct contact with an activity is in the best position to make the estimates since he has the best knowedge of local conditions, thus the budget will be more accurate and reliable ( realistic)
c) An individual is more motivated to work at achieving the budget if she had a say in developing it
d) The participative budget has its own unique system of control; If people are not able to meet the budget they only have themselves to hold responsible, if the budget is imposed from above , they can make excuses that the budget was unreasonable or unrealistic
e) However with such freedom given to management, top management must review and approve the budget
Budgetary slack
Budgetary slack is the difference between a budget estimate that a person that a person provides and the realistic estimate. Creatign a budgetary slack is also known as padding the budget
The incentive bias is to understate budgeted revenues and over state the budgeted expenses.
An organization can reduce the problem of budgetary slack in several ways
a) Avoid relying on the budget as a negative ( punitive ) evaluative tool.
b) Managers can be given incentives not only to achieve budgetary projections but also to provide accurate projections
Whether or not a budget is accepted by lower management personnel is reflective of
– how top management use budgeted data
– acceptance and support of the persons who occupy key management positions
– should not use budgets to use to pressure employees and use it for blame settings
– budgets should be use as a positive / constructive instrument
– establishing goals
– isolating areas in need of attention( management by exception)
Management must keep in mind that human dimension in budgeting is a key of importance. Easy for manager to become preoccupied with technical aspects of the budgets to motivate employees to achieve the companys objectives
Imposed budgets ( top down approach )
Best time to use would be during :
Start up of new organisations, small businesses , economic crisises, lack of budgetary skills and when the organizational units require precise coordination of efforts
The advantages of this system would be probably that the organization plans to be incorporated into planned activities, coordination among divisional plans , top management knowledge of overall resource availability, reduce possibility of input from inexperienced or uninforment lower level employees, time frame.
The disadvantage would be dissatisfaction , reducing feeling of team work , may limit the acceptance of the new stated goals , punitive budget psychology for employees, and may result in unachievable budgets for international divisions if the local operating and political environment is not adequately considered. Also it may stifle initiative of lower level managers
Participatory budgets ( Bottom up approach )
Best times
> in well established organisations
> large businesses
> economy booming
> Operating managers have strong budgetary skills
> Budgetory departments are quite autonomous ( independent)
Advantages :
> Obtains information from those persons most familiar with the needs and constraints of the organizational units
> better morale and job satisfaction and also motivation
> realistic budget
> Develop fiscal responsibility and budgetary skills of employees
> Specific resource requirements of organizational units
> Top management overview with operating details
> Knowledge diffused among various levels of management.
Disadvantages
> Requires more time
> Slack introduction in budgets
> unrealistic budget sometimes as managers may be unqualified to participate in the budgeting process.
Key features of a sound budgetary system
a) Frequent feedback on performance. Managers have to know how they are doing as the year unfolds and take corrective action as needed.
b) Flexible budgeting , a static budjet is for a particular level of activity. It is not reasonable to compare actual costs at one level of activity with budgeted cost for a different level of activity.
c) Monetary and nonmonetary incentives. – used to induce a manager to work towards the organization goals
d) Participative budget- allow managers in the budgetary process to increase goal congruence , creativity and such
e) Realistic standards- efficiency , seasonal variations, general economic conditions
f) Controllability
g) Multiple measures of performance
Zero base budgeting
Non profit , governmental and service type organizations
A) Starts at zero budget and justify all costs as if the program involved being initiated for the first time
B) No cost ongoing
C) Priotizing
Traditional budgeting
Based on incremental approach ,. Start with last year budget and add/ substract from it according to anticipated inflation
Expenses can fluctuate , zero based budgeting would ask if we need to spend that money , is it justified to spend it. It is time consuming and expensive
Master budget preparation
Starts with sales budget , The sales budget has a domino effect – a chain reaction because the other budgets are based on it , Production is dependent on sales, direct materials and moh budgets based on production
Sales forecasting is critical
1) Past experience
2) Prospective pricing policy ( price elasticity considerations)
3) Unfilled order backlogs
4) Market research studies
5) Economic conditions
6) Advertising and product promotion
7) Industry outlook
8) Competition
Cash Budget
Why is cash budget so critical?
Avoids unnecessary supplies. If the company short of cash it is best to know as early as possible that the company can plan to raise cash at the lowest cost or find the best value and use for excess cash – invest it or decrease debt or pay dividends.
Creditors require cash budget as part of the business plan.
One of management key tasks is to control costs
How ? By controlling prices paid and or quantity used
We need to develop standard “ should be doing “ , Based on expectations
Groupd decision making process
a) Compare ideal standards vs practical standards
Lets say practical standards are 90 % but ideal standards are 100 percents
If you want to do corrective actions to fix , if you get an 80 % then you can fix it but if you are on the noramal standards then you need to look into it
Standards need to reflective of efficient future operations not inefficient past operations.
Standards need to realistic and practical if the variations from them are used fairly and constructively then employees will generally be motivated to work for the organizational objectives covered by standards
Direct materials standards
a) Quality of materials
b) Quantity purchased
c) Method of freight
d) Receiving and handling costs
The standard per unit should reflect the final delivered cost of the material involved
Standard quantity per direct material
Used for direct material should reflect the amount of material needed to produce a good finished unit of product. In determining standard quantity
a) Design patterns
b) Unavoidable waste
c) Expected spoilage
d) Normal rejects
All of these are non value added activities, we want to eliminate them and reduce them to efficient levels
3.5 metres here means that for every jogging suit manufactured we should use 3.5 metres
If 200 suits was actually manufactured we should use 3.5 metres*200= 700 metres
Threfore the standard cost would be material * cost = 3.5 m *6 m=21 $ per jogging suit
Direct labour standards
The standard rate per hour should reflect all cost with direct labour workers
This include
Union hourly rate
Expected labour mix
Benefits
Employment/ payroll taxes
Standard rate per hour would be basic wage weight
Standard hours per unit would be direct labour amount we should be using for one good finished unit of product
This time should include the following elements
> Engineered time per unit
> allowance for breaks , personal needs and cleanup
> aloowance for machine downtime
> allowance for rejects “ defective units”
The standard should take if its normal .
Standards hours here
Allowance for breaks and cleanup, allowance for machine downtime and allowance for rejects ect
For every jogging suit actually manufactured we should use 2 hours then if i make 300 suits i shoud use 600 hours
Therefore the standard cost for direct labour would be 2 hours * 18=36 per jogging suit
Variable overhead standards
Variable overhead standards are expressed in terms of rate per activity
The rate is the variable portion of the predetermined overhead rate ( poh )
POH rate = estimated variable overhead / estimated activity level.
Therefore if its said that the variable portion is 4 $ per dlh
Then we can say that the variable overhead cost would be 2 hours * 4 hour = 8 $
The standard cost card would be direct materials , direct labour and variable overhead , a standard cost card can be prepared. The standard cost card shows the manager what the final , manufactured cost should be for a unit of product
Direct materials standard q * price = standard cost
Direct labour standard q* price = standard cost
Variable overhead= standard q * price = standard cost
Total variable cost = dm +dl + voverhead
Knowing the standard price per unit help management price special orders or bid on contracts
When there is excess capacity the 65 would be the minimum price variable selling and administration
Prepare a flexible budget for any level of production.
Standard vs Budget
A standard is a unit amount, a budget is a total amount , the standard is the budgeted cost for one unit of product.
What are the budgeted variable costs of producing 1000 jogging suits
1000*65= 65 000
What is the expected increase in production if we produce 50 more jogging suits= 50*65 = 3250 $
But ignore fixed cost as they dont change with total , but make sure that understand that total fixed cost doesn’t change within the relevant range
Advantages of standard costs
Management by exception
a) Actual vs standard = variance
b) Material significance are followed
1) Facilate planning
2) Expected costs are available before operations are conducted
3) Can be used to assist in strategic and operational analysis
Promote Economy and efficiency
Resposability accounting
Disadvantages of standard costs
How do we know which variances are material / significant ?
How do we know which variances are material ?
Really hard to know until end of year
1) Other useful information may be missed by focussing only on material variances , other information may be noticed at an early stage
2) Behavioural consequences
– Subordinates may be tempted to cover up negative exceptions or not report them at all
Subordinates may not receive recognition for the positive things they do
3) Supervisors adversely affected by management by exception
– not receiving complete review of operations focussing only on the problem areas being bad cop, morale may suffer.
5) Variances reports are not timely ; they are not prepared until the actual costs are collected , may not be useful for controlling ongoing operations
5) A tendency to cut costs to meet standards which may result in a lower quality and higher warranty costs
7) in a competitive environment , meeting standards may not be good enough, we need to strive for continual improvement .
Variance analysis
General model for dm dl and voh exists which is very useful in variance analysis . This model helps to distinguish between price variances and quantity variances
Why is it helpful
For dm , decisions relating to price paid and quantity used occur at different points in time when purchased vs when used ( Not much an issue when considering jit)
Consider price paid and quantity used,responsibility of different managers
Variance is difference between actual prices and quantities and standard price and quantities
Variance price and quantity
/————————————————-/————————————————————-/
Aq*AP AQ*SP SQ*SP
Price variance materials quantity variance
1-2 2-3
HERE AQ IS ACTUAL QUANTITY SP, STANDARD PRICE , SQ= STANDARD QUANTITY AND STANDARD PRICE ( SP)
The term standard quantity allowed in the case of dm dl and vmoh means the amount should have been used to calculate the actual output, for dm / dl / moh sq is based on actual output since dm dl and moh are variable costs and the more less the output , the more
Direct material variance
Following data are available for feb 2012 production
Num of suits 5000
Cost of material purchased ( 2000 m @ 5.40) 108000$
Metres of material used 20000
STANDARD QUANTITY THEREFORE 5000*3=15000
Material price and quantity
/—————————————-/—————————————————-/
AQ*QP AQ*SP SQ*SP
20000*5.40 20000*6 17500*6
108000 120000 105000
Price variance therefore 12000 f quantity = 15000 u
Paid less than should have paid more than should have
Total variance therefore 3000 u
If variance would be favourable the sign would be negative vc as ap < sp
Unfourable would be positive sign as positive variance AP> SP , PAID MORE THAN SHOUD HAVE
Whos is responsible , generally purchasing department but sometimes maybe the responsibility of the production manager due to last minute scheduling
for quantity variance it would be production manager but its inferior of quantity purchased then purchasing agent would be responsible
favourable vs unfourable – doesn’t mean good or bad but look at total ictial
favourable ( underbudget) actual income > budgeted income
Low quality materials would result in more usage and defective units and thus unfavourable would mean in more usage and thus an unfavourable materials quantity variance.
Low quality materials may result in higher warranty cost, which would result in lower sales due to unhappy customers
Purchase in bults you will get a better price but increase storage costs and usage there fore money is tied up in inventory materials which is also going to be an opportunity cost.
Direct labour RATE and efficiency variance
Gortex inc jogging suit , the following data are available for February 2012 production
Number of jogging suits completed 5000
Cost of direct labour ( 10500 hours at 20 $) 210000
AH* AR AH* AR SH*SR
/——————————————/————————————————-/
10500*20 10500*18 10000*18
RATE EFFICIENCY
5000* 2 =10000 hours
Rate variance : 21 000 U 9000 U
Total variance : 30 000 U
Labour rate variance 10500 ( 20-18 ) = 21000 u
Who is responsible : the result of the way labour is used skilled workers doing unskilled work, overtime ect , thus responsibility for the LRV with the supervisor in charge of the use of labour time
Labour efficiency variance ( LEV)
9000 u
Poossible cause
Poorly trained new causes , taking longer, poor quality materials , faulty equipment
Unskilled workets doing work
Who is responsible ? Supoervisor In charge of the use of labour time , rest with the purchasing department though if inferior quality materials purchased or the maintainance department purchased or maintainance department agegnt quality materials purchased or maintainance department manager for work stoppage due to equipment breakdowns
Variable overhead variances
What base was used to apply overhead? DLH
VOH is comprised of power, supplies , ect , utilities and maintainance
The following data are available for feb production
Number of suits overhead 5000
Actual dl hours 10500
Cost of variable overhead 40950
Actual voh actual hrs at sr ( AH*SR) SH*SR
40950 10500*4 ( POH ) 10000*4
42000 40000 (Applied)
/———————————————————–/———————————————————/
Spending variance 1050 f efficiency 2000 U
Where 5000 hours *2.0 hours per suit = 10000 hours
Total variance 950 u
Key thing to note is that in the applied overhead , the standard costing system it is the SQ*SR
The variable overhead spending variance = Actual voh – ( AH*SR) = 10 50 F
The spending variance contains elements of waste or excessive usage as well as price differentials ( unlike dm and dl which have separate price and usage variances)
Variable efficiency variance
Is not a measure of the efficiency of variable overhead, instead it is a measure of the efficiency of the base used to apply variable overhead that was used .
Since overhead is applied using DLH , if the LEV is unfavourable , then the LEV is unfavourable ( U then will the vohev be favourable ( F ) or U ?
Unfavourable since DLH is being used to apply overhead
Variance analysis and management by exception
What is an exception ?
> Materiality is the guidelines that differs from budget by 5 % or more
> Supplemented with some minimum absolute figure ( depending on the size of company )
Actual = 2 $ and budget = $ 1 , what is the percentage variance and should we investigate?
% of variance =2-1/1= 100% but insignificant
1) Consistency of occurrence – if variance comes clost to limits of materiality consistently , then it may be some indication that the standard cost need updating
2) Ability to control some cost that are largely beyond management control like property taxes thus no follow up action is needed even if variances are material
3) Nature of item , some costs are much more critical to long run profitability than others , thus these cost variances are more closely monitored
4) Statistical analysis is viewed as a range rather than a point , as these variations within control limits are viewed as occurring due to random causes therefore not followed up.
Direct materials variances
AQ*AP AQ*SP AQ* SP SQ*SP
PRICE QUANTITY
/—————————–/ /————————————/
Quantity purchased Quantity used
Quantity purchased ( Aqp)= Quantity used if
Company uses JIT
Ending inventory would be Beginnning inventory if inventory levels haven’t changed,
BI+P- used thus if BI = EI then p= used
If quantity purchased is not the same as quantity used then then we cant compute the total variance
Note that the quantity purchased vs quantity used is not applicable for DL because DL cant be stored.
Example
Static master budget was 12000*65 = 65000 $
Now the end of the year the company produced 9000 jogging suits , the actual moh was 600000 $
To determine whether company has done a good job of controlling variable moh cost we would
Choice one
Compare actual costs vs master budjet
Actual cost was 600000 ( 9000 suits )
Static budget 780000 then the variance would be 180 000 F
However we looking at actual costs which vary in total with the number of jogging suits actually produced
Therefore we cant compare actual variable costs for 9000 jogging suits ith a budget for 12000 jogging suits. We should compare results with a flexible budget ( 9000 suits)
Choice two
Actual costs 600000
Flexible costs would be 9000*65 = 585 k therefore variance would be 15000 U , therefore it was based on the actual number of joggin suits produced
Conclusion would be that gortex in has not done a good job of controlling variable moh costs.
Significance of variance investigation
To determine if mpv is significant you compare to AQ*SP
To determine if quantity is significant you compare to SQ*SP
THEREFORE IF ITS GREATER THATN 5 PERCENT of the standard amount , should have paid or should have used amount
Question one ¸
UBC manufactures books for use in classes. The standard cost for material and labour is 89.20$ per book ( 8 kg *5 ) +( 6hours * 8.20). This includes 8 kilograms of direct material at a standard cost of 5.00 $ per kilogram and 6 hours of direct labour at a standard rate of 8.20 per hour the data pertains to November :
a) Wip inventory November one : none
b) Work in process on November 30 : 800 units ( 75 percent complete as to labour , material is issued at the beginning of processing )
c) Units completed is 56000units
d) Purchases of materials : 50000 kg for 249 250 $
e) Total actual labour costs are $ 300 760
f) Actual labour costs are 300760 $
g) Direct material quantity variance : 1500 unfavourable
What is the equivalent finished products of direct materials in November ewip and what is the November output
DM in ewip is 100 percent complete because material is added/issued at the beginning fo the period November actual output is 5600+800 (100 %)= 6400 units
What is the equivalent finished units of direct labour in November ewip and what is November output
RE DL in ewip is 75 percent
November actual output re DM would be
5600+ 800 ( 75 %)= 6200 units
Direct materials
AQ*AP AQ*SP AQ*SP SQ*SP
/————-750 f—————-/ /—————1500u——————–/
50000*4.95 50000*5 51200*5 51200*5
249250 250000 257500 256000
Standard quantity would be actual output 6400 units *8 kg= 51200
For total variance aqp not equal aqu then cant compute total variance
Direct labour variance
/—————-1460U——————————–/—————————-5740F————/
AH *AR AH*SR SH*SR
36500*8.24 36500*8.20 37200*8.20
300760 299300 305040
SH= 6200 UNITS * 6 HOURS = 37200 HOURS
TOTAL VARIANCE WOULD BE 1460U +5740 F=4280 F