Cambridge AS & A Level9706

Budgeting and budgetary control (A Level)

Accounting 9706 Chapter Notes

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Budgeting and budgetary control (A Level)
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In this chapter

  1. 1Introduction to Budgeting
  2. 2The Budgeting Process and Limiting Factors
  3. 3Sales, Production, and Purchases Budgets
  4. 4The Cash Budget
  5. 5The Master Budget
  6. 6Budgetary Control and Flexible Budgets
  7. 7Evaluating Budgeting Systems

1. Introduction to Budgeting

A budget is a financial plan for a future period, usually a year. It's a roadmap expressed in numbers, detailing expected income and expenditure. Businesses use budgets for several key reasons: to plan ahead (Planning), to ensure all departments are working towards the same goals (Coordination), to inform managers of their targets (Communication), to encourage staff to meet targets (Motivation), and to measure performance by comparing the plan to actual results (Control). Budgets can be created using an incremental approach, where the previous year's budget is adjusted (e.g., by 5%), or a zero-based approach, where every expense must be justified from scratch, as if starting from zero.

Key term

Budget: A quantitative plan of action, expressed in monetary terms, for a specific time period, used for planning and control.

Worked example 12 marks

A business had sales of $500,000 last year. The sales director wants to budget for a 12% increase in sales for the coming year. What is the budgeted sales revenue for next year?

  1. 1

    Step 1: Identify the current year's sales: $500,000.

  2. 2

    Step 2: Identify the budgeted percentage increase: 12% or 0.12.

  3. 3

    Step 3: Calculate the monetary value of the increase: $500,000 * 0.12 = $60,000.

  4. 4

    Step 4: Add the increase to the current year's sales to find the budget for next year: $500,000 + $60,000 = $560,000.

  5. 5

    Alternatively, calculate directly: $500,000 * 1.12 = $560,000.

Recap

  • A budget is a financial plan for the future.
  • Budgets are used for planning, coordination, communication, motivation, and control.
  • Incremental budgeting adjusts last year's figures.
  • Zero-based budgeting starts from scratch and justifies all costs.

Quick check

  1. State two purposes of a budget.2 marks
  2. What is the key difference between incremental and zero-based budgeting?2 marks

2. The Budgeting Process and Limiting Factors

Budgets cannot be prepared in a random order; they are interconnected and must follow a logical sequence. The process starts by identifying the 'principal budget factor' or 'limiting factor'. This is the one thing that restricts the business's activity level for the budget period. For most businesses, the limiting factor is sales demand – you can't sell more than customers are willing to buy. However, it could also be a shortage of raw materials, insufficient machine capacity, or a lack of skilled labour. Once the limiting factor is identified, the budget for that factor is prepared first, and all other budgets (known as functional budgets) follow on from it. For example, if sales is the limiting factor, you prepare the sales budget first, which then determines the production budget, which in turn determines the material purchases and labour budgets.

Key term

Principal Budget Factor: The factor that limits an organisation's activities for a given period, which must be identified first to ensure all subsequent budgets are realistic.

Examiner insight

Examiners expect you to identify the principal budget factor first and explain why it dictates the order of budget preparation. Show your calculations for each potential constraint.

Fun fact

In many tech companies, the principal budget factor isn't sales or materials, but the availability of highly specialised software engineers.

Worked example 14 marks

A company can sell up to 20,000 units of its product. Each unit requires 2kg of material X and 3 hours of direct labour. For the next budget period, the company can only source 35,000kg of material X and has 63,000 hours of labour available. Identify the principal budget factor.

  1. 1

    Step 1: Determine the maximum units possible based on each potential constraint.

  2. 2

    Step 2: Sales Demand: Maximum is 20,000 units.

  3. 3

    Step 3: Material X: Available material is 35,000kg. Each unit needs 2kg. Maximum units = 35,000kg / 2kg/unit = 17,500 units.

  4. 4

    Step 4: Direct Labour: Available labour is 63,000 hours. Each unit needs 3 hours. Maximum units = 63,000 hours / 3 hours/unit = 21,000 units.

  5. 5

    Step 5: Compare the maximum units from each factor: Sales (20,000), Material (17,500), Labour (21,000).

  6. 6

    Step 6: The lowest number is 17,500 units, which is constrained by the availability of material X. Therefore, the availability of material X is the principal budget factor.

Recap

  • The budgeting process must start with the principal budget factor.
  • The principal budget factor is the constraint that limits the business's activity.
  • Common limiting factors include sales demand, materials, labour, or machine capacity.
  • Once the principal budget is set, all other functional budgets follow in a logical sequence.

Quick check

  1. If sales demand is the limiting factor, which budget should be prepared first?1 mark

3. Sales, Production, and Purchases Budgets

These three budgets are the foundation of the master budget. The Sales Budget is the starting point (assuming sales is the limiting factor) and forecasts the expected sales volume and revenue. The Production Budget then calculates how many units need to be produced to meet sales demand, while also adjusting for desired changes in finished goods inventory. Finally, the Raw Material Purchases Budget determines the quantity and cost of raw materials that must be bought to fulfil the production plan, also accounting for desired changes in raw material inventory.

Budgeted Production (units) = Budgeted Sales (units) + Closing Inventory (units) - Opening Inventory (units)

Budgeted Material Purchases (quantity) = Material for Production + Closing Inventory (quantity) - Opening Inventory (quantity)

Budgeted Purchases Cost = Budgeted Material Purchases (quantity) × Cost per unit of material

Key term

Production Budget: A budget that details the number of units that must be produced to meet the sales forecast and satisfy inventory requirements.

Common pitfall

Forgetting to adjust for opening and closing inventory. Many students simply assume production equals sales.

Worked example 16 marks

Raj Limited has budgeted sales for September of 900 units and for October of 800 units. The company policy is to hold closing inventory of finished goods equal to 10% of the following month's sales. Each unit requires 2kg of material. Calculate for September:(i) The production budget in units.(ii) The material usage budget in kg.

  1. 1

    Part (i): Production Budget (units) for September

  2. 2

    Step 1: Identify budgeted sales for September: 900 units.

  3. 3

    Step 2: Calculate required closing inventory for September. This is 10% of October's sales: 10% * 800 units = 80 units.

  4. 4

    Step 3: Calculate opening inventory for September. This would have been the closing inventory for August, which was 10% of September's sales: 10% * 900 units = 90 units.

  5. 5

    Step 4: Apply the production budget formula: Production = Sales + Closing Inventory - Opening Inventory.

  6. 6

    Step 5: Production = 900 + 80 - 90 = 890 units.

  7. 7

    Part (ii): Material Usage Budget (kg) for September

  8. 8

    Step 6: Identify the number of units to be produced in September (from part i): 890 units.

  9. 9

    Step 7: Identify the material required per unit: 2kg.

  10. 10

    Step 8: Calculate total material needed for production: 890 units * 2kg/unit = 1780 kg.

Recap

  • The sales budget drives the production budget.
  • The production budget drives the material purchases and labour budgets.
  • Always account for opening and closing inventory when preparing production and purchases budgets.
  • The formula is always: What you need = What you'll use + What you want left - What you already have.

Quick check

  1. A firm plans to sell 500 units. It has 50 units in opening inventory and wants 70 units in closing inventory. How many units must it produce?2 marks

4. The Cash Budget

The cash budget is one of the most important financial plans. It forecasts the movement of cash in and out of the business over a period. Its primary purpose is to help managers anticipate future cash surpluses or shortages and plan accordingly. It is crucial to remember that a cash budget tracks *cash*, not profit. This means we only include actual cash receipts and payments. Key differences from the Statement of Profit or Loss include: credit sales are only included when the cash is received from the customer, credit purchases are only included when the supplier is paid, and non-cash expenses like depreciation are completely excluded. Capital expenditure (buying non-current assets) and loan receipts/repayments are included as they are cash movements.

Net Cash Flow = Total Cash Inflows - Total Cash Outflows

Closing Cash Balance = Opening Cash Balance + Net Cash Flow

Key term

Cash Budget: A detailed forecast of all expected cash receipts and cash payments of a business over a future period, used to manage liquidity.

Examiner insight

Examiners frequently test the timing of cash flows. Always create a small timeline or table to track when sales are made, when cash is received, when purchases are made, and when they are paid for.

Fun fact

Many profitable businesses have failed because they ran out of cash. This is why the cash budget is often considered the most critical short-term planning tool.

Worked example 110 marks

Using the following information for Raj Limited for August, prepare a cash budget.

  • Cash balance at 1 August: $20,000.
  • Sales are on one month's credit. July sales were 600 units at $50 each.
  • Materials are paid for two months after purchase. Material purchases in June were $65,000.
  • Wages ($14/hr, 2hrs/unit) and variable overheads ($15/unit) are paid in the month incurred. Production in August is 990 units.
  • Fixed overheads are paid in the following month. Fixed overheads for July were $3,600.
  1. 1

    Step 1: Set up the cash budget format for August with Inflows, Outflows, Net Cash Flow, and Balances.

  2. 2

    Step 2: Calculate Cash Inflows. Cash is received one month after sale. So, cash from August sales is received in September. Cash received in August is from July's sales. Inflow = 600 units * $50 = $30,000.

  3. 3

    Step 3: Calculate Cash Outflows.

  4. 4
    • Payment for materials: Paid two months after purchase. Payment in August is for June's purchases. Outflow = $65,000.
  5. 5
    • Payment for wages: Paid in the month incurred. Production is 990 units. Labour cost = 990 units * 2 hours/unit * $14/hour = $27,720.
  6. 6
    • Payment for variable overheads: Paid in the month incurred. Cost = 990 units * $15/unit = $14,850.
  7. 7
    • Payment for fixed overheads: Paid in the following month. Payment in August is for July's overheads. Outflow = $3,600.
  8. 8

    Step 4: Sum total outflows: $65,000 + $27,720 + $14,850 + $3,600 = $111,170.

  9. 9

    Step 5: Calculate Net Cash Flow for August: Total Inflows - Total Outflows = $30,000 - $111,170 = ($81,170).

  10. 10

    Step 6: Calculate Closing Cash Balance: Opening Balance + Net Cash Flow = $20,000 + (-$81,170) = ($61,170).

  11. 11

    Final Cash Budget for August:

  12. 12

    Opening Balance: $20,000

  13. 13

    Cash Inflows:

  14. 14

    Receipts from receivables: $30,000

  15. 15

    Total Inflows: $30,000

  16. 16

    Cash Outflows:

  17. 17

    Payments for materials: $65,000

  18. 18

    Payments for wages: $27,720

  19. 19

    Payments for variable overheads: $14,850

  20. 20

    Payments for fixed overheads: $3,600

  21. 21

    Total Outflows: $111,170

  22. 22

    Net Cash Flow: ($81,170)

  23. 23

    Closing Balance: ($61,170)

Recap

  • A cash budget tracks the flow of cash, not profit.
  • Exclude all non-cash items like depreciation.
  • Pay close attention to the timing of receipts from credit sales and payments for credit purchases.
  • The closing balance of one period becomes the opening balance of the next.
  • A forecast deficit allows management to arrange finance in advance.

Quick check

  1. A business makes sales of $20,000 in May, all on one month's credit. How much cash from these sales will be shown in the May cash budget?1 mark

5. The Master Budget

The Master Budget is the grand summary of all the lower-level functional budgets. It brings everything together to provide a complete picture of the organisation's expected financial future for the budget period. It consists of two main components: the Budgeted Statement of Profit or Loss and the Budgeted Statement of Financial Position. The Budgeted Statement of Profit or Loss forecasts the company's trading performance and profitability, using figures from the sales, production, and overheads budgets. The Budgeted Statement of Financial Position predicts the company's assets, liabilities, and equity at the end of the budget period, using information from all other budgets, especially the cash budget.

Key term

Master Budget: A comprehensive financial plan for an organisation, comprising a budgeted statement of profit or loss, a budgeted statement of financial position, and a cash budget.

Worked example 15 marks

A company has prepared the following budget totals for the year: Sales revenue $250,000; Opening inventory of finished goods $20,000; Closing inventory of finished goods $15,000; Cost of goods produced $140,000; Operating expenses $60,000. Prepare the budgeted statement of profit or loss for the year.

  1. 1

    Step 1: Start with the heading: Budgeted Statement of Profit or Loss for the year ended...

  2. 2

    Step 2: List Sales Revenue: $250,000.

  3. 3

    Step 3: Calculate the Cost of Sales. The formula is Opening Inventory + Cost of Goods Produced - Closing Inventory.

  4. 4

    Step 4: Cost of Sales = $20,000 + $140,000 - $15,000 = $145,000.

  5. 5

    Step 5: Calculate Gross Profit: Sales Revenue - Cost of Sales = $250,000 - $145,000 = $105,000.

  6. 6

    Step 6: Subtract Operating Expenses to find the Net Profit: $105,000 - $60,000 = $45,000.

  7. 7

    Final Statement:

  8. 8

    Sales Revenue: $250,000

  9. 9

    Cost of Sales: ($145,000)

  10. 10

    Gross Profit: $105,000

  11. 11

    Operating Expenses: ($60,000)

  12. 12

    Budgeted Net Profit: $45,000

Recap

  • The master budget is the final summary of all individual budgets.
  • Its main components are the budgeted statement of profit or loss and the budgeted statement of financial position.
  • It provides a holistic view of the expected performance and position of the business.
  • The cash budget is also a key component of the master budget.
  • Preparing the master budget is the final step in the budgeting process.

Quick check

  1. What are the two primary financial statements that make up the master budget?2 marks

6. Budgetary Control and Flexible Budgets

Budgeting isn't just about planning; it's also about control. Budgetary control is the process of comparing actual results against the budgeted figures, investigating any significant differences (variances), and taking corrective action. However, a simple comparison can be misleading. A 'fixed budget' is prepared for only one level of activity. If actual production is higher or lower than planned, comparing actual costs to the fixed budget is like comparing apples and oranges. This is where a 'flexible budget' is essential. A flexible budget adjusts the original budget to the *actual* level of activity achieved. This is done by taking the variable costs per unit from the original budget and multiplying them by the actual number of units produced, while keeping the fixed costs the same. This creates a meaningful benchmark to compare actual costs against.

Flexible Budget Cost = (Actual Activity Level × Variable Cost per unit) + Budgeted Fixed Costs

Key term

Flexible Budget: A budget that is adjusted to the actual level of output, allowing for a more meaningful comparison of actual costs to budgeted costs.

Examiner insight

Marks are awarded for correctly flexing the variable costs to the new activity level while keeping the fixed costs unchanged (within the relevant range).

Fun fact

Flexible budgeting is crucial in industries with volatile demand, like fashion or seasonal tourism, where actual activity rarely matches the initial plan.

Worked example 15 marks

A company's fixed budget for producing 10,000 units is: Direct Materials $40,000; Direct Labour $60,000; Variable Overheads $20,000; Fixed Overheads $50,000. In the period, the company actually produced 11,000 units. Prepare a flexible budget for the actual activity level of 11,000 units.

  1. 1

    Step 1: Separate costs into variable and fixed. Variable costs = Materials + Labour + Variable Overheads. Fixed costs = Fixed Overheads.

  2. 2

    Step 2: Calculate the variable cost per unit from the original fixed budget. Total variable cost = $40,000 + $60,000 + $20,000 = $120,000. Variable cost per unit = $120,000 / 10,000 units = $12 per unit.

  3. 3

    Step 3: 'Flex' the variable costs to the actual activity level. New total variable cost = 11,000 units * $12/unit = $132,000.

  4. 4

    Step 4: Keep the fixed costs the same as in the original budget. Fixed costs = $50,000.

  5. 5

    Step 5: Combine the flexed variable costs and the fixed costs to get the total flexible budget. Total = $132,000 + $50,000 = $182,000.

  6. 6

    Final Flexible Budget for 11,000 units:

  7. 7

    Variable Costs: $132,000

  8. 8

    Fixed Costs: $50,000

  9. 9

    Total Budget Cost: $182,000

Recap

  • Budgetary control involves comparing actual results to the budget and taking action.
  • A fixed budget is prepared for a single level of activity.
  • A flexible budget is adjusted to the actual level of activity.
  • To flex a budget, recalculate variable costs for the actual activity level but keep fixed costs the same.
  • Flexible budgets provide a more meaningful basis for performance evaluation.

Quick check

  1. A fixed budget for 5,000 units shows variable costs of $10 per unit and fixed costs of $20,000. What is the total budget cost if flexed to 6,000 units?3 marks

7. Evaluating Budgeting Systems

While essential, budgetary control systems have both significant advantages and disadvantages. On the positive side, they compel managers to plan for the future, promote coordination between departments, provide clear targets that can motivate staff, and are often required by banks to secure financing. They help identify potential problems before they arise. However, they also have drawbacks. Preparing budgets is very time-consuming and can be expensive. Because they are prepared months in advance, they can become outdated due to unforeseen events. If budgets are imposed from the top down without consultation, or are seen as overly restrictive, they can demotivate staff and lead to dysfunctional behaviour, such as managers spending their entire budget just to avoid having it cut next year. Using spreadsheets or specialist accounting software can make the preparation process much faster and more accurate, but the underlying human and strategic challenges remain.

Key term

Budgetary Control: The process of using budgets to monitor and control the performance of a business by comparing actual results with budgeted figures and taking corrective action.

Worked example 18 marks

The directors of a company argue that preparing budgets is a waste of time and that the accountant should stop doing them. Evaluate this argument. [8 marks]

  1. 1

    Introduction: State that while the directors' concerns about the time and cost are valid, abandoning budgeting entirely would be a mistake.

  2. 2

    Argument for the directors' view (Disadvantages):

  3. 3
    • Budgeting is time-consuming and costly, diverting management time from other activities.
  4. 4
    • Budgets can become outdated quickly in a fast-changing market, making them irrelevant.
  5. 5
    • If targets are unrealistic, they can demotivate staff rather than motivate them.
  6. 6
    • Can lead to rigid decision-making, where managers are afraid to deviate from the plan even if a good opportunity arises.
  7. 7

    Argument against the directors' view (Advantages):

  8. 8
    • Without budgets, there is no formal planning, leading to 'management by crisis'.
  9. 9
    • Budgets are essential for coordinating the activities of different departments towards a common goal.
  10. 10
    • They provide a benchmark for performance evaluation and control, without which it's hard to know if the business is on track.
  11. 11
    • Banks and lenders require budgets (especially cash budgets) before providing finance, so abandoning them could restrict access to capital.
  12. 12

    Conclusion: Conclude that despite the disadvantages, the benefits of planning, coordination, and control that budgets provide are vital for any well-run business. The solution is not to abandon budgeting, but to improve the process, perhaps by using rolling budgets or involving managers more.

Recap

  • Advantages of budgeting include improved planning, coordination, motivation, and control.
  • Disadvantages include being time-consuming, becoming outdated, and potentially causing demotivation.
  • Spreadsheets and software can improve the efficiency and accuracy of budget preparation.
  • Effective budgeting involves participation from managers, not just imposition from the top.
  • The benefits of a well-implemented budgeting system generally outweigh the costs.

Quick check

  1. State two advantages and two disadvantages of a budgetary control system.4 marks

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. Explain the role of the 'principal budget factor' in the preparation of budgets.3 marks
  2. A company budgets to sell 12,000 units in Quarter 1 and 15,000 units in Quarter 2. Company policy is to maintain a closing inventory of finished goods equal to 20% of the next quarter's sales. The opening inventory for Quarter 1 is 2,400 units. Calculate the production budget in units for Quarter 1.4 marks
  3. Distinguish between a fixed budget and a flexible budget, explaining why a flexible budget is more useful for control purposes.5 marks
  4. A business has a fixed budget for 20,000 units. At this level, variable costs are $100,000 and fixed costs are $80,000. Prepare a flexible budget for an actual production level of 22,000 units.5 marks
  5. A cash budget for March shows an opening balance of $5,000, cash receipts of $40,000, and cash payments of $48,000. The business also plans to purchase a new machine for $10,000 cash in March. Calculate the closing cash balance for March.4 marks
  6. Discuss two advantages and two disadvantages of involving departmental managers in the budget-setting process.8 marks
  7. A company produces a single product. Budgeted production for May is 4,000 units. Each unit requires 3 hours of labour at a rate of $12 per hour and 5kg of material at a cost of $2 per kg. The company holds no inventory of materials. Calculate for May: (i) The direct labour cost budget. (ii) The material purchases budget in dollars.6 marks
  8. A business makes all sales on credit, with 60% of customers paying in the month of sale and 40% paying in the month after. Budgeted sales are: April $50,000; May $70,000. Calculate the budgeted cash receipts from customers for May.4 marks
  9. Explain why depreciation on non-current assets is excluded from a cash budget but included when calculating budgeted profit.4 marks
  10. The sales budget is 8,000 units. Opening finished goods inventory is 500 units and desired closing inventory is 700 units. Each unit requires 2kg of raw material at $5/kg. Opening raw material inventory is 1,000kg and desired closing inventory is 800kg. Calculate the material purchases budget in dollars.8 marks

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