Chapter 7 - Aspects Of Budgeting Flashcards
What is a Budget?
A budget is a financial plan for a business that is prepared in advance.
Budgets are based on pre-determined costs and revenues set in advance of production. Pre-determined costs and revenues are often referred to as standard costs and standard selling prices.
Budgeted/Standard costs and revenues are set for:
Direct materials - Budgeted materials cost is the expected quantity and quality of materials multiplied by the expected material price.
Direct labour - Budgeted labour cost is the expected labour hours multiplied by the expected wage rates.
Production overheads - The expected volume of output within a time period multiplied by the overhead absorption rate determines the budgeted overhead cost.
Sales revenue - The expected volume of sales within a time period multiplied by the expected selling price determines the budgeted sales revenue.
Operating profit - The expected operating profit within a time period.
Budgets are usually set for each of the responsibility centres. Once budgets have been set they can used as part of the decision making, planning and control processes.
Fixed budgets
A fixed budget remains the same whatever the level of activity.
A fixed budget is set at the beginning of the time period for planning purposes and then monitored. Fixed budgets are useful in situations where circumstances are stable. E.g a department budget for a school where a set amount of money is allowed for buying stationary.
Flexible budgets
A flexible budget changes with the level of activity and takes into account different cost behaviour patterns.
A flexible budget is altered for control purposes to vary in line with the level of activity of a business - ie with output of products sold or services provided. By doing this the right costs and revenues are matched and variances can be calculated.
When preparing a flexible budget, fixed overheads will not change due to changes in the level of output but they may change dos to price. E.g rent is increased.
Fixed and variable costs in budgeting and decision making
Identifying costs as being fixed, semi-variable or variable helps with budgeting and decision making - the business might be able to alter the balance between fixed and variable costs in order to increase profits.
Knowledge of the behaviour of costs can be used to help management to:
Identify the amount of fixed costs within a semi variable cost
Prepare flexible budgets for revenue and costs
Identify the point at which costs are exactly equal to income known as the break even point
Indentifying the amount of fixed and variable costs
Semi variable costs combine both a fixed and variable costs. It is important to be able to identify the amount of each as this will help with budgeting and decision making.
Where the total costs are known at two levels of output, the amounts of fixed and variable costs can be identified using the high/ low method as the difference in the costs at different output levels will be due solely to the variable costs.
The high low method can only be used when variable costs increase by the same money amount for each extra unit of output and where there are no stepped fixed costs.
Budgets for revenue and costs
Once fixed and variable costs are known for the three elements of costs it is relatively simple to calculate how to the costs will change at different levels of output.
Budgeted contribution
Many budgets are set out in such a way as to show the contribution to fixed overheads.
Budgets and variances
A variance is the difference between the budgeted/ standard cost or revenue and the actual cost or revenue.
Actual revenue - budgeted revenue = variance
Budgeted cost - actual cost = variance
Management by exception
The control systems of a business will set down procedures for acting on variances but only for significant variances. This type of system is known as management by exception.
Managers will normally work to tolerance limits - a tolerance limit is an acceptable percentage variance on the budgeted amount. If a cost or revenue exceeds the tolerance limit action will need to be taken.
Who needs to know about variances?
Variances against budgeted cost or revenue need to be reported to the appropriate level of management within the business.
This depends on the significance of the variance. E.g cost of materials used goes up by one percent then the managing direct will unlikely to be interested and it will go to the purchasing department. However if there has been a major failure and cost have increase a lot then the matter would be brought to the higher management.
Motivating employees
Budgets are an example of responsibility accounting. This can be a method of motivation as budgets can be seen as a carrot or stick so that it is a form of encouragement to achieve amounts set or as a form of punishment if pre determined costs are exceeded or sales revenues not achieved.
Reporting and investigating variances
The variances for the cost elements and class revenues are summarised on a budget report. These reports reconcile the budgeted cost and the actual cost for each cost element and the budgeted revenues and show the variances.
Percentages are always calculated by dividing the variance by the budgeted figure.
The order for investigating variances shown by the budget report is usually as follows:
Large variances - favourable and adverse
Other adverse variances
Any remaining favourable variances
*Also the small variances may not be worth investigating - the cost of the investigation might outweigh the benefits.
Reporting cycle
For budget reports to be used effectively it is essential that employees are trained to record information accurately about actual costs and revenues. The quality of the information must be:
Accurate
Timely
In the appropriate format highlighting major features
The reporting cycle of a budget report depends on the time periods used. E.g if a business establishes budget reports on the basis of monthly periods then variances are likely to be reported within the first two weeks of the next period.
Revision of budgets
At regular intervals (commonly annually) the budgeted costs and revenues need to be revised to take note of:
Cost increases caused by inflation
Changes to specifications and quality of materials. E.g improvement in quality leads to less wastage
Changes to work practices. E.g increase in automation may lead to reduced labour costs
Changes to selling prices which may be limited by competitors
Controllable and non - controllable costs and revenues
Controllable costs - costs and revenues which can be influenced by the manager/ supervisor
Non controllable costs - costs which cannot be influenced by the manager/ supervisor in the short term
In the long term all costs and revenues are controllable.
