Cost and Management Accounting
Academic Notes for MBA 2 Sem Students
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UNIT III - Budgets and Budgetary
Control
15. Introduction to Budgets and
Budgetary Control
15.1
Meaning of Budget
A budget is a formal, quantitative
expression of management’s plans for a specified future period. It represents a
detailed financial plan that outlines expected revenues, expenses, and resource
requirements for achieving organizational objectives. Budgets serve as roadmaps
for organizational activities and provide benchmarks for performance
evaluation.
The Chartered Institute of Management
Accountants (CIMA) defines a budget as “a quantitative expression of a plan for
a defined period of time. It may include planned sales volumes and revenues,
resource quantities, costs and expenses, assets, liabilities and cash flows.”
Key Characteristics of Budgets: -
Expressed in quantitative terms (usually monetary) - Cover a specific time
period - Based on predetermined objectives and policies - Require formal
approval from management - Serve as tools for planning, coordination, and
control
15.2
Meaning of Budgetary Control
Budgetary control is a system
of management control that involves the preparation of budgets, continuous
comparison of actual results with budgeted figures, and taking corrective
action to ensure organizational objectives are achieved.
Components of Budgetary
Control: - Planning: Setting realistic and achievable targets - Coordination:
Ensuring all departments work toward common goals - Communication:
Conveying organizational objectives throughout the organization - Motivation:
Encouraging performance improvement - Control: Monitoring actual
performance against budgets - Evaluation: Assessing performance and
identifying areas for improvement
15.3 Objectives of Budgetary Control
Primary Objectives:
- Provide a framework for planning future operations - Coordinate activities
across different departments and levels - Communicate management’s expectations
throughout the organization - Motivate employees to achieve organizational
goals - Provide standards for performance evaluation - Facilitate control
through variance analysis - Assist in resource allocation decisions
Secondary Objectives:
- Improve operational efficiency - Reduce costs and eliminate waste - Maximize
profit and return on investment - Ensure optimal utilization of resources -
Provide basis for management by exception - Create accountability at all
organizational levels
16.
Types of Budgets
Budgets can be classified using various
criteria based on their purpose, time period, and flexibility.
16.1 Classification by
Time Period
Long-term
Budgets (Strategic Budgets): - Cover periods exceeding one year (typically
3-10 years) - Focus on strategic planning and major capital investments -
Provide broad guidelines for organizational direction - Examples: Capital
expenditure budgets, strategic revenue projections
Short-term
Budgets (Operational Budgets): - Cover periods up to one year (monthly,
quarterly, annually) - Focus on detailed operational planning - Provide
specific targets for day-to-day operations - Examples: Monthly sales budgets,
quarterly production budgets
16.2 Classification by
Function
Operating
Budgets: - Related to regular business operations - Include revenue and
expense budgets - Examples: Sales budget, production budget, administrative
expense budget
Financial
Budgets: - Related to financial position and cash flows - Include balance
sheet and cash flow projections - Examples: Cash budget, capital expenditure
budget, budgeted balance sheet
16.3 Classification by
Flexibility
Fixed
Budgets (Static Budgets): - Prepared for a specific level of activity -
Remain unchanged regardless of actual activity levels - Suitable for stable,
predictable environments
Flexible
Budgets (Variable Budgets): - Adjusted based on actual activity levels -
Provide more meaningful comparisons for control purposes - Better suited for
dynamic business environments
16.4 Other Types of Budgets
Functional
Budgets: - Sales Budget - Production Budget - Material Budget - Labor
Budget - Overhead Budget - Administrative Budget - Research and Development
Budget
Master
Budget: - Comprehensive budget incorporating all functional budgets -
Represents the overall financial plan for the organization - Culminates in
budgeted financial statements
17. Steps in Budgetary Control
17.1 Budget
Preparation Process
Step
1: Establishment of Budget Centers - Identify responsibility centers within
the organization - Define scope and authority of each budget center - Assign
budget responsibility to specific managers
Step
2: Budget Manual Preparation - Develop comprehensive guidelines for budget
preparation - Include policies, procedures, and formats - Specify roles and
responsibilities of various personnel
Step
3: Budget Committee Formation - Establish a committee to oversee the
budgeting process - Include representatives from different functional areas -
Define committee authority and decision-making processes
Step
4: Setting Budget Objectives - Align budget objectives with organizational
strategy - Establish clear, measurable, and achievable targets - Communicate
objectives throughout the organization
Step
5: Budget Factor Identification - Identify the principal budget factor (key
limiting factor) - Common budget factors: sales demand, production capacity,
raw material availability
Step
6: Budget Preparation - Prepare individual functional budgets - Ensure
coordination between different budgets - Review and revise as necessary
Step
7: Budget Approval - Present budgets to appropriate authority levels -
Obtain formal approval before implementation - Communicate approved budgets to
relevant personnel
17.2
Budget Implementation and Control
Step
8: Budget Implementation - Distribute approved budgets to responsible
managers - Provide necessary resources and support - Establish reporting and
monitoring systems
Step
9: Performance Monitoring - Compare actual results with budgeted figures -
Calculate and analyze variances - Prepare regular performance reports
Step
10: Corrective Action - Investigate significant variances - Implement
corrective measures where necessary - Revise budgets if fundamental assumptions
change
18. Fixed vs. Flexible Budgeting
18.1 Fixed Budgeting
Fixed budgets are prepared for a single level of activity and
remain unchanged regardless of actual activity levels achieved.
Characteristics of Fixed Budgets: - Based on a
predetermined activity level - All figures remain constant throughout the
budget period - Simple to prepare and understand - Suitable for organizations
with stable activity levels
Advantages: - Simple and economical to prepare - Easy
to understand and implement - Provides definite targets for planning - Suitable
for policy formulation
Disadvantages: - Unrealistic comparisons when activity
levels vary - May discourage efficiency improvements - Less useful for cost
control purposes - Cannot accommodate changing business conditions
18.2 Flexible
Budgeting
Flexible budgets are designed to change with variations in
activity levels, providing more realistic benchmarks for performance
evaluation.
Characteristics of Flexible Budgets: - Prepared for
multiple activity levels or adjusted for actual activity - Variable costs
change proportionally with activity - Fixed costs remain constant within
relevant range - Provides meaningful comparisons for control
Advantages: - More realistic performance comparisons
- Better cost control through meaningful variance analysis - Accommodates
changing business conditions - Helps distinguish between efficiency and volume
variances
Disadvantages: - More complex and expensive to
prepare - Requires detailed cost behavior analysis - May be time-consuming to
implement - Requires sophisticated accounting systems
Formula for Flexible Budget: Flexible Budget Cost =
Fixed Cost + (Variable Cost per Unit × Actual Activity Level)
Example: Original budget for 10,000 units: - Fixed
costs: ₹50,000 - Variable costs: ₹30 per unit - Total budgeted cost: ₹350,000
If actual production is 12,000 units: Flexible budget cost
= ₹50,000 + (₹30 × 12,000) = ₹410,000
19. Functional Budgets
19.1 Sales Budget
The
sales budget is typically the starting point of the budgeting process as it
determines the level of activity for most other budgets.
Components
of Sales Budget: - Forecasted sales quantities by product/service -
Expected selling prices - Sales revenue projections - Sales by territory,
customer, or time period
Factors
Affecting Sales Budget: - Market research and demand analysis - Economic
conditions and industry trends - Competitive environment - Company’s marketing
strategies - Historical sales data and trends
Sales
Budget Format:
Sales Budget for [Period]
Product A:
Quantity (units) XXX
Price per unit XXX
Total sales revenue XXX
Product B:
Quantity (units) XXX
Price per unit XXX
Total sales revenue XXX
Total Sales Revenue XXX
19.2 Production Budget
The
production budget determines the number of units to be produced to meet sales
requirements and maintain desired inventory levels.
Formula:
Required Production = Planned Sales + Desired Ending Inventory - Beginning
Inventory
Production
Budget Format:
Production Budget for
[Period]
Expected sales (units) XXX
Add: Desired ending
inventory XXX
Total requirements XXX
Less: Beginning
inventory XXX
Required production
(units) XXX
Example:
- Expected sales: 8,000 units - Desired ending inventory: 1,500 units -
Beginning inventory: 1,200 units
Required
production = 8,000 + 1,500 - 1,200 = 8,300 units
19.3 Raw Material
Consumption Budget
This
budget determines the quantity and cost of raw materials required for planned
production.
Formula:
Material Required for Production = Production Units × Material Required per
Unit
Raw
Material Consumption Budget Format:
Raw Material Consumption
Budget for [Period]
Material A:
Production requirement (units) XXX
Material per unit XXX
Total material required XXX
Cost per unit XXX
Total cost XXX
Material B:
Production requirement (units) XXX
Material per unit XXX
Total material required XXX
Cost per unit XXX
Total cost XXX
Total Material Consumption
Cost XXX
19.4 Raw Material
Purchase Budget
This
budget determines the quantity and cost of raw materials to be purchased,
considering inventory requirements.
Formula:
Material Purchases = Material Required for Production + Desired Ending
Inventory - Beginning Inventory
Raw
Material Purchase Budget Format:
Raw Material Purchase Budget
for [Period]
Material A:
Required for production XXX
Add: Desired ending inventory XXX
Total requirements XXX
Less: Beginning inventory XXX
Purchases required (units) XXX
Cost per unit XXX
Total purchase cost XXX
Total Raw Material Purchase
Cost XXX
Example:
- Material required for production: 5,000 kg - Desired ending inventory: 800 kg
- Beginning inventory: 600 kg - Cost per kg: ₹12
Purchases
required = 5,000 + 800 - 600 = 5,200 kg Total purchase cost = 5,200 × ₹12 = ₹62,400
19.5 Overhead Budgets
Overhead
budgets include all indirect costs associated with production and operations.
Types
of Overhead Budgets:
Manufacturing
Overhead Budget: - Indirect materials - Indirect labor - Factory utilities
- Depreciation on factory equipment - Factory rent and insurance
Administrative
Overhead Budget: - Office salaries - Office supplies and utilities -
Professional fees - Depreciation on office equipment
Selling
and Distribution Overhead Budget: - Sales salaries and commissions -
Advertising and promotion - Transportation and delivery costs - Customer
service expenses
Overhead
Budget Format:
Manufacturing Overhead
Budget for [Period]
Variable Overhead:
Indirect materials XXX
Indirect labor XXX
Utilities (variable portion) XXX
Other variable overhead XXX
Total variable overhead XXX
Fixed Overhead:
Depreciation XXX
Insurance XXX
Rent XXX
Utilities (fixed portion) XXX
Other fixed overhead XXX
Total fixed overhead XXX
Total Manufacturing
Overhead XXX
20.
Cash Budget
20.1 Importance of Cash Budget
The
cash budget is crucial for liquidity management and ensures adequate cash
availability for operations while avoiding excessive cash holdings.
Objectives
of Cash Budget: - Forecast cash receipts and payments - Identify periods of
cash surplus or shortage - Plan for short-term financing needs - Optimize cash
management and investment decisions - Coordinate cash flows with business
activities
20.2 Components of Cash Budget
Cash
Receipts: - Collections from customers (accounts receivable) - Cash sales -
Interest and dividend income - Sale of assets - Loan proceeds - Other income
sources
Cash
Payments: - Payments to suppliers (accounts payable) - Direct labor
payments - Manufacturing overhead payments - Operating expense payments -
Capital expenditures - Loan repayments - Tax payments - Dividend payments
20.3 Cash Budget Format
Cash Budget for [Period]
Beginning Cash Balance XXX
Cash Receipts:
Collections from customers XXX
Cash sales XXX
Other receipts XXX
Total cash receipts XXX
Cash Payments:
Raw material purchases XXX
Direct labor XXX
Manufacturing overhead XXX
Operating expenses XXX
Capital expenditures XXX
Other payments XXX
Total cash payments XXX
Net Cash Flow XXX
Ending Cash Balance (before
financing) XXX
Financing:
Borrowings XXX
Repayments XXX
Interest payments XXX
Net financing XXX
Ending Cash Balance XXX
20.4 Cash Budget Example
Monthly
cash budget for ABC Company:
Cash Budget - January 2024
Beginning Cash Balance ₹25,000
Cash Receipts:
Collections from customers ₹180,000
Cash sales ₹45,000
Total cash receipts ₹225,000
Cash Payments:
Raw material purchases ₹80,000
Direct labor ₹35,000
Manufacturing overhead ₹25,000
Operating expenses ₹40,000
Equipment purchase ₹50,000
Total cash payments ₹230,000
Net Cash Flow (₹5,000)
Ending Cash Balance (before
financing) ₹20,000
Minimum cash balance
required ₹30,000
Cash shortage ₹10,000
Financing:
Bank loan ₹15,000
Ending Cash Balance ₹35,000
21.
Master Budget
21.1 Definition and Components
The
master budget is a comprehensive financial planning document that integrates
all individual budgets into a cohesive plan for the entire organization.
Components
of Master Budget:
Operating
Budgets: - Sales budget - Production budget - Raw material budget - Direct
labor budget - Manufacturing overhead budget - Cost of goods sold budget -
Selling and administrative expense budget
Financial
Budgets: - Cash budget - Capital expenditure budget - Budgeted income
statement - Budgeted balance sheet - Budgeted cash flow statement
21.2 Master Budget
Preparation Process
Step
1: Prepare sales budget (starting point) Step 2: Prepare production
budget based on sales forecast Step 3: Prepare raw material, labor, and
overhead budgets Step 4: Prepare cost of goods sold budget Step 5:
Prepare selling and administrative expense budget Step 6: Prepare cash
budget Step 7: Prepare budgeted income statement Step 8: Prepare
budgeted balance sheet Step 9: Prepare budgeted cash flow statement
21.3 Benefits of Master Budget
•
Provides comprehensive view of organizational
plans
•
Ensures coordination between different
functional areas
•
Facilitates performance evaluation and control
•
Supports decision-making processes
•
Helps identify potential problems in advance
•
Serves as communication tool for stakeholders
22. Zero-Based Budgeting (ZBB)
22.1
Introduction to Zero-Based Budgeting
Zero-Based
Budgeting is a budgeting technique where all expenses must be justified from
scratch for each budget period, starting from a “zero base.” Unlike traditional
budgeting that uses previous year’s budget as a starting point, ZBB requires
managers to build their budgets from the ground up.
Key
Principles of ZBB: - Every function and expense must be justified - No
automatic carryover from previous periods - Alternative ways of performing
activities are evaluated - Resources are allocated based on merit and necessity
- Focus on eliminating unnecessary expenses
22.2 Steps in
Zero-Based Budgeting
Step
1: Identify Decision Units - Define discrete activities or functions to be
analyzed - Ensure decision units are manageable and meaningful - Examples:
departments, programs, projects, or functions
Step
2: Develop Decision Packages - Create detailed descriptions of each
decision unit - Include objectives, activities, resources required, and costs -
Develop multiple levels of effort for each package: - Minimum level (essential
activities only) - Current level (maintaining status quo) - Enhanced level
(improved or expanded activities)
Step
3: Evaluate and Rank Decision Packages - Assess each package based on
predetermined criteria - Consider cost-benefit analysis, strategic alignment,
and necessity - Rank packages in order of priority
Step
4: Allocate Resources - Allocate available resources to highest-priority
packages - Continue down the ranking until resources are exhausted - Document
decisions and rationale
Step
5: Prepare Final Budget - Compile approved decision packages into formal
budget - Ensure consistency and completeness - Communicate budget decisions to
relevant stakeholders
22.3 Decision Package
Format
Decision Package:
[Function/Activity Name]
Objective: [Clear statement
of purpose]
Description of Activities:
- [Detailed list of
activities included]
Resources Required:
- Personnel: XXX
- Equipment: XXX
- Materials: XXX
- Other expenses: XXX
Total Cost: XXX
Benefits Expected:
- [Quantitative and
qualitative benefits]
Consequences of Not Funding:
- [Impact of elimination or
reduction]
Alternative Approaches:
- [Different ways to achieve
objectives]
Performance Measures:
- [Key metrics for
evaluation]
22.4
Advantages of Zero-Based Budgeting
Cost
Control Benefits: - Eliminates unnecessary expenses and outdated programs -
Identifies cost reduction opportunities - Prevents automatic budget increases -
Encourages efficient resource utilization
Management
Benefits: - Forces critical evaluation of all activities - Improves
understanding of operations - Encourages innovative thinking - Aligns resource
allocation with strategic priorities
Organizational
Benefits: - Promotes accountability and responsibility - Enhances
communication and coordination - Supports organizational change and adaptation
- Improves decision-making processes
22.5
Disadvantages of Zero-Based Budgeting
Implementation
Challenges: - Time-consuming and labor-intensive process - Requires
significant management involvement - May face resistance from employees - Needs
extensive training and support
Practical
Limitations: - Difficult to quantify benefits of some activities - May not
be suitable for all types of organizations - Can create excessive paperwork and
bureaucracy - Risk of eliminating important long-term activities
Cost
Considerations: - High implementation and maintenance costs - Requires
sophisticated analytical capabilities - May need external consulting support -
Annual repetition can be burdensome
22.6
Applications of Zero-Based Budgeting
Most
Suitable For: - Government and non-profit organizations - Service
organizations with discretionary spending - Organizations undergoing major
restructuring - Companies in mature or declining industries - Situations
requiring significant cost reduction
Examples
of Successful Implementation: - Government agencies eliminating redundant
programs - Corporate overhead reduction initiatives - Research and development
budget optimization - Marketing and advertising budget evaluation
23. Integration and Best Practices
23.1
Budget Integration Principles
Horizontal Integration: - Coordinate
budgets across different functions - Ensure consistency in assumptions and data
- Align departmental objectives with organizational goals
Vertical Integration: - Link operational
budgets with strategic plans - Connect short-term budgets with long-term
objectives - Ensure top-down and bottom-up communication
23.2
Best Practices in Budgetary Control
Budget Preparation: - Involve
relevant personnel in budget development - Use realistic assumptions and
reliable data - Allow sufficient time for thorough preparation - Build in
flexibility for changing conditions
Budget Implementation: -
Communicate budgets clearly to all stakeholders - Provide adequate training and
support - Establish clear accountability measures - Monitor performance
regularly
Budget Review and Control: -
Conduct timely variance analysis - Focus on significant deviations from budget
- Take prompt corrective action when necessary - Learn from budget versus
actual comparisons
23.3 Common
Budgeting Pitfalls
•
Setting unrealistic or unattainable targets
•
Inadequate consideration of external factors
•
Poor communication of budget objectives
•
Insufficient involvement of operational managers
•
Over-reliance on historical data
•
Failure to adapt to changing circumstances
•
Inadequate variance analysis and follow-up
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