Chapter Three

Information for budgeting, planning & control purposes

Definition of budget
 Budget is the quantitative expression of a proposed plan of action by management for
a future time period and is an aid to the coordination and implementation of the plan.
 Budget is a financial or quantitative statement prepared prior to a specified
accounting period, containing the plans and policies to be pursued during that period.
 Budget is a detailed plan, expressed in quantitative terms, that specifies how
resources will be acquired and used during a specified period of time.
 A budget generally includes both financial and nonfinancial aspects of the plan, and it
serves as a blueprint for the company to follow in an upcoming period.
Budgeting as a multipurpose activity

Activity-based budgeting (ABB) is an alternative budgeting practice. Traditional

methods are more simplistic, adjusting prior period budgets to account for inflation or
revenue growth. Rather than using past budgets to calculate how much a firm will spend
in the current year, activity-based budgeting (ABB) digs deeper.

Activity-based budgeting (ABB) is not necessary for all companies. For example,
established firms that experience minimal change typically find that applying a flat rate to
data from the previous year to reflect business growth and inflation is sufficient.

In contrast, newer companies without access to historical budgeting information cannot

consider this an option. Activity-based budgeting (ABB) is also likely to be implemented
by firms undergoing material changes, such as those with new subsidiaries, significant
customers, business locations, or products. In these types of cases, historical information
may no longer be a useful basis for future budgeting.

 Activity-based budgeting (ABB) is a method of budgeting where activities that

incur costs are recorded, analyzed and researched.
 It is more rigorous than traditional budgeting processes, which tend to merely
adjust previous budgets to account for inflation or business development.
 Using activity-based budgeting (ABB) can help companies to reduce costs and, as
a result, squeeze more profits from sales.
 This method is particularly useful for newer companies and firms undergoing
material changes.

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  Using activity-based budgeting (ABB) can help companies to reduce the
activity levels required to generate sales. Eliminating unnecessary costs
should boost profitability.
The activity-based budgeting (ABB) process is broken down into three steps.

1. Identify relevant activities. These cost drivers are the items responsible for
incurring revenue or expenses for the company.
2. Determine the number of units related to each activity. This number is the
baseline for calculations.
3. Delineate the cost per unit of activity and multiply that result by the activity level.

Example of Activity-Based Budgeting

Company A anticipates receiving 50,000 sales orders in the upcoming year, with
each single order costing $2 to process. Therefore, the activity-based budget
(ABB) for the expenses relating to processing sales orders for the upcoming year
is $100,000 ($50,000 * $2).
This figure may be compared to a traditional approach to budgeting. If last year’s
budget called for $80,000 of sales order processing expenses and sales were
expected to grow 10%, only $88,000 ($80,000 + ($80,000 * 10%)) is budgeted.

Advantages and Disadvantages of Activity-Based Budgeting

Activity-based budgeting (ABB) systems allow for more control over the budgeting
process. Revenue and expense planning occurs at a precise level that provides useful
details regarding projections. ABB allows for management to have increased control over
the budgeting process and to align the budget with overall company goals.

Unfortunately, these benefits come at a cost. Activity-based budgeting (ABB) is more

expensive to implement and maintain than traditional budgeting techniques and more
time consuming as well. Moreover, ABB systems need additional assumptions and
insight from management, which can, on occasion, result in potential budgeting
inaccuracies.

Behavioral Aspects in Budgeting

How the budget is administrated will affect their effectiveness and efficiency in achieving
the organization’s goals. Besides using budget to forecast the organization’s coming
year’s performance, it also serves another purpose. It can be used as a performance
evaluation on the managers’ actual performance against the budgeted performance. By
doing so, the organization is trying to use budget as a tool for control. When the
performance evaluation is linked with any form of rewards and penalty system, there are
possibilities that the managers will distort any information and data passed to upper level
of management (i.e. their superiors). The managers may underestimate the revenue, over-
estimate the costs required. It can have an effect on their job performance, which will be

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reflected on their annual appraisals. All these will affect their salary increment, annual
bonus, chances of promotion etc.
Below are the behavioral aspects of budgeting, which will arise:
Dysfunctional Behavior; when the budget’s goals are the same as managers’ goals, the
actual performance will meet the expected level of performance or even exceed the
expectations. This is called goal congruence. It refers to the alignment and consistency of
individual’s goals (in this instance, it is the manager) with the organizations’ goals. The
managers will be motivated to aim for the goals of the organization, as this will also lead
them towards their individual goals. In the case of goal incongruence, the managers are
not motivated at all. They may put in minimum efforts (in worst case scenario, no efforts
from the managers) towards the budget, thus affecting the actual performance. Adverse
effect on his job appraisal.
Participative Budgeting; Budget is usually prepared either top down or bottom up.
Under the top-down budget method, top management prepares the budget and pass on the
information to the employee as what they need to do in the budget. There is no
involvement and communication from other employee. When there is participation from
the employee, they become involved in the budgeting process. They form part of the
budget.

Budgetary Slack; The difference between the allocated resources and the actual required
resources is the budgetary slack. The managers introduce the budgetary slack, also known
as padding the budget, during the budget preparation process. They will underestimate
the revenues and overestimate the costs and expenses. In this way, they can request for
more allocation of resources from the organization. There is a tendency for the managers
to do in almost all organizations, across industries.
Budgetary control:
·Budgetary Control is a method of managing costs through preparation of budgets.
Budgeting is thus only a part of the budgetary control.
A control technique whereby actual results are compared with budgets. Any differences
(variances) are made the responsibility of key individuals who can either exercise control
action or revise the original budgets.
The main features of budgetary control are:
• Establishment of budgets for each purpose of the business.
• Revision of budget in view of changes in conditions.
• Comparison of actual performances with the budget on a continuous basis.
• Taking suitable remedial action, wherever necessary.
• Analysis of variations of actual performance from that of the budgeted performance to
know the reasons thereof.
Budgetary control and responsibility centers; These enable managers to monitor
organizational functions.

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A responsibility center can be defined as any functional unit headed by a manager who
is responsible for the activities of that unit.
There are four types of responsibility center’s:
a) Revenue centers Organizational units in which outputs are measured in monetary terms
but are not directly compared to input costs.
b) Expense centers Units where inputs are measured in monetary terms but outputs are
not.
c) Profit centers where performance is measured by the difference between revenues
(outputs) and expenditure (inputs). Inter-departmental sales are often made using
"transfer prices".
d) Investment centers where outputs are compared with the assets employed in producing
them, i.e. ROI.
Type of budget
Based on budgeting strategies:-
1. Mandated Budgeting:-It relies on predetermined standards set by upper level
managers for its budget levels. It is also known as top-down budgeting because top
management develops the budget and passes them down the organizational hierarchy
to various divisions and/or departments without input from lower levels of
management and employees.
2. Participative budgeting: - It allows individuals who are affected by the dub get to
have input into the budgeting process. It also known as button-up budgeting because
the budgeting process begins at lower levels of the organizational hierarchy and
continues up through the organization to top management. This budgeting strategy is
beneficial in that most people will perform better and make greater attempts to
achieve a goal if they have been consulted in setting the goal. Such participation can
give employees the felling that “ this is our budget,” rather than this is the budget you
imposed on us.
3. Incremental Budgeting: - is a strategy whereby the company uses the current
period’s budget as a starting point in preparing the next period’s budget. In the
traditional approach to budgeting, the manager starts with last year’s budgets and
adds to or subtracts from it according to anticipated needs. This is an incremental
approach to budgeting in which the previous year’s budgets is taken for granted as a
baseline.

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4. Zero-Based Budgeting: - is a strategy in which the company begins each budget
period with a zero budget and requires consideration of every activity undertaken by
the department or segment. Zero based budgeting is alternative approach that is
sometimes used particularly in the governmental and not for profit sectors of the
economy. Under a zero base budget, managers are required to justify all budgeted
expenditures, not just changes in the budget from the previous year. The zero base
budgeting approach forces management to rethink each phase of an organizations
operations before allocating resources. In zero base budgeting there is no “givens”. It
stars with the basic premise that the budget for next year is zero and that every
expenditure, old or new, must be justified on the basis of its cost and benefit.
Classification of Budgets According to Time: According to this classification, budgets
are divided in the following categories.
1. Short Term Budget: Any budget that is prepared for a period up to one year is
known as Short Term Budget. Functional budgets are normally prepared for a
period of one year and then it is broken down month wise.
2. Medium Term Budget: Budget prepared for a period 1-3 years is Medium Term
Budget. Budgets like Capital Expenditure, Manpower Planning are prepared for
medium term.
3. Long Term Budgets: Any budget exceeding 3 years is known as Long Term
Budgets. Master Budget is normally prepared for long term. In the modern days
due to uncertainty, very few budgets are prepared for long term.
Based on capacity:
Based on the capacity, budgets are classified as fixed and flexible budgets.
1. Fixed Budgets: A flexible budget is one which will remain unchanged immaterial of
the level of activity these budgets are prepared for fixed expenses and their aim is to
control cost. A fixed budget is rigid and does not change with the volume of activity
achieved. A fixed budget is prepared for a particular level of activity and for a
particular set of conditions. It is prepared under the premise that there will be no
change in the outside conditions.

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2. Flexible Budgets: These budgets will change with the change in activity these
budgets are prepared for various level of activity. While preparing flexible budgets
the expenses are broadly classified as fixed, variable and semi-variable expenses.
A flexible budget can be changed to suit the level of activity to be achieved. Flexible
budget is not rigid. Flexible budgets are prepared for various levels of activities.
Based On Time
Though budgets may cover long periods (called long-range budgets), the most frequently
used budget period is one year (short-range budgets). The annual budget is often
subdivided by months for the first quitter and by quarters for the remainder of the year.
Companies are increasingly using rolling budgets. A rolling budget is always available
for a specified future period by adding a period (month, quarter, or year) in the future as
the period just ended is dropped. Rolling budgets are sometimes called revolving
budgets or continuous budgets. Therefore continuous (rolling) budget is a budget
system that has a budget for a set number of months, quarters, or years at all times–as one
period ends another is added
Based on coverage
On the basis of coverage, budgets are classified as functional and master budget.
i. Functional budgets
It represents the budgets that relates to the various functional activities of an organization.
Functional budgets are classified as physical budgets, profit budgets, cost budgets and
financial budgets.
ii. Master budgets
Activity: What is master budget?
Definition: Master budgets are the consolidated summary of various functional budgets.
It is the aggregation of all lower-level budgets produced by a company's various
functional areas, and also includes budgeted financial statements, cash forecast, and a
financing plan. The master budget is typically presented in either a monthly or quarterly
format, or usually covers a company's entire fiscal year.
A master budget is the central planning tool that a management team uses to direct the
activities of a corporation, as well as to judge the performance of its
various responsibility centers.

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Thus, budget represents the “grand plan of action” for an upcoming period and
translates the organization’s short-term objectives into action.
2.4. DEVELOPING THE MASTER BUDGET
The master budget expresses management’s operating and financial plans for a
specified period (usually a year) and comprises a set of budgeted financial
statements. The two main components of the master budget are the operating
budget and the financial budget.
Components of operating budget
A. the sales budget
 The starting point of budgeting
 Includes both cash and credit sales
 A detailed schedule showing the expected sales for the budgeted period
B. The schedule of expected cash collection
Prepared to show how match cash expected to be received from customers
Includes- current month’s cash sales plus
-the previous month’s credit sales expected to be collected in the current month
C. The inventory (merchandise) purchase budget
Prepared to show the amount of goods to be purchased from suppliers during the period
The total amount of inventory needed can be obtained from two sources
1. Beginning inventory and
2. The company’s planned purchases
The inventory purchase budget format
Budgeted cost of goods sold--------------- xxxxxx
Add: desired ending inventory ----------- xxxxxx
Total inventory needed -------------------xxxxxx
Less: Beginning inventory ---------------xxxxxx
Required purchase --------------------------xxxxxx
D. the schedule of expected cash disbursements for purchases
A disbursement for inventory purchased consists of payments for purchases on account
made in prior periods plus any payment for inventory purchases made on the current
budget period.

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 E. operating expense budget
All budgeted selling and administrative expenses would be compiled and listed down.
The amount of interest expense cannot be determined until the amount of expected
borrowing has been established through the preparation of cash budget.
F. The schedule of expected cash disbursements for operating expenses
Cash expense are paid as incurred
Depreciation expense is not included in the cash disbursements for operating expenses.
Because depreciation is non cash expense
G. The budgeted or pro – forma income statements
It shows the company’s planned profit for the upcoming budget period.
It will be complete after addition of the interest expense, which is computed after the cash
budget, has been prepared.
The main reason why the budgeted income statement is prepared before the cash budget
is to show that the ultimate output of the operating budget (in budgeted income
statement.)
Components of financial budget
Financial budget consists
1. Capital budget: plan for the acquisition of capital assets such as building and
equipment
2. Cash budget: prepared to advise management of anticipated cash shortage or
excessive cash balances.
It is a statement of planned cash receipts and disbursements and pulls together much of
the data developed in the preceding steps:
It is composed of four sections
A. Receipt (cash collection) sections: consists of a listing of all of the cash inflows
B. Disbursement (cash payment) sections: consists all cash payments that are planned
for the budget period
- Includes: raw materials - Dividends
purchased - Manufacturing costs
- Direct labor payments - Operating expense and so on
- Equipment purchases

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c. Cash excess or deficiency sections: it is computed as:
Beginning cash balance ---------------------xxx
Add: receipts ----------------------------------xxx
Total cash available before financing ----xxx
Less: disbursements ------------------------ xxx
Excess (deficiency) of cash ----------------- xxx
C. Financing sections: includes
 Borrowings
 Repayments
 Interest payments
3. budgeted balance sheet
4. budgeted statements of cash flows
NB: Preparation of the master budget begins with the preparation of the planned operating
budget, whereas, production budget is set after sales budget is completed.
Master budget for Merchandising Firms
Example: Aman Company is a merchandising firm and office supplies specialty stored in Addis
Ababa. The company prepares its master budget in quarterly basis. The following data have been
assembled to assist in the preparation of the master budget for the first quarter of 2005.
a. As December 31, 2004, the following general ledger showed the following account balances.
Debit Credit
Cash $ 48,000
Account receivable 224,000
Inventory 60,000
Building and equipment 370,000
Account payable $93, 000
Capital stock 500 000
Retained earnings 109,000
702,000 702,000

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b. Actual sales for December 2004 and budgeted sales for the next four months of 2005 are as
follows:
December (actual) sales 280,000
Budgeted sales of 2005
January 400, 000
February 600,000
March 300,000
April 200, 000
c. Sales are for 20% for cash and 80% on credit. All payments on credit sales are collected in
the month following sale. The account receivable at December 31, 2004 is a result of
December credit sale.
d. The company’s gross profit is 40% of sales in a month
e. Monthly expenses are budgeted as follows.
Salaries and wages 27,000 per month
Advertising 70,000 per month
Shipping 5% of sales
Depreciations 14,000 per month
Other expenses 3% of sales

*Note that cash expenses are paid as incurred .

f. Desired ending inventory equals to 25% of the following month’s sales needs, stated at cost
(cost of goods sold).
g. 50% of month’s inventory purchases are paid for in the month of purchase and the remaining
50% is paid for the following month.
h. During February the company will purchase a new copy machine for $1,700 cash. During
March other equipment will be purchased for cash at a cost of $ 84,500
i. During January the company will declare and pay $45,000 in cash dividends.
j. The company must maintain a minimum cash balance of $30,000 each month. All borrowing
is made at the beginning of a month and all payments are paid at the end of a month.
Borrowings and repayments of principal must be in multiples of $1000 (countable in
thousands). Interest is paid only at the time of payment of principal. The annual interest rate
is 12%.
Required: Using the data for Aman Company, you are required to prepare the necessary
operating and financial budget.
Solution 1-Operating budget

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a. Sales Budget
Aman Company
Sales Budget
For the quarter ended March 31,2005
Months
January February March Quarter
Budgeted cash sales (20%) 80,000 120,000 60,000 260,000
Budgeted credit sales (80%) 320,000 480,000 240,000 1,040,000
Total Budgeted sales 400,000 600,000 300,000 1,300,000

b. Schedule of budgeted cash collection

Aman Company
Cash Collection Budget
For the quarter ended, March 31, 2005

Months
January February March Quarter
Account receivable 224,000 --- ------- 224,000
beginning balance

January sales (400,000*20%, 400,000*80%) 80,000 320,000 ------ 400,000

February sale (600,000*20%, 600,000*80%) 120,000 480,000 600,000

March sale (300,000*20%) 60,000 60,000

60,000 60,000
Total cash collection 304,000 440,000 540,000 1,284,00
0

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 c. The inventory (merchandise) purchase budget
Aman Company
Inventory (Merchandise) purchase Budget
For the quarter ended, March 31, 2005
Months
…………………… January …… February …. March ...… Quarter

Budged cost of goods sold

(60% of sale because gross profit is 40%) ... ………… 240,000…360,000 ……180,000 ………780, 000
Add: Desired ending inventory…………………………90,000 … 45,000 …………30,000….……30,000
Total inventory needed………………………………... 330,000 ....405,000…… .210,000……...810, 000
Less: Beginning inventory……………………………60,000……90,000…………45,000……...60,000*
Required purchase……………………………… 270,000……315,000 ………. 165,000…….750,000
Note: *Because the beginning of quarter is the same as the beginning inventory of January
d. Schedule of expected cash disbursements for inventory purchases
Aman Company
Schedule of expected cash disbursements for inventory purchases
For the quarter ended, March 31, 2005
Months
……January ……...February……. March ………Quarter
Accounts payable beginning balance ……...93,000 ……... - …... - …….. …... 93,000
January purchases (270,000*50%, 50%) 135,000 135,000 - .......---------.270, 000
February purchases (315,000*50%, 50%) … …………….157, 000 ……157,000……315, 000
March Purchases (165,000*50%, 50%) …….. -……………..- …82,500 ……...82,500
Total disbursements for purchases ……...228,000 ………….292,500 ...... 240,000 ……... 760,500
e. The operating expense Budget
Aman Company
Operating expense Budget for the quarter ended, March 31, 2005
Months
…………January ……...February……. March ………Quarter
Salaries and wages ………………………...27,000 27,000 27,000…………81,000
Advertising expense ………………………70,000………. 70,000 …………...70,000……… …210,000

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Shipping (5% sales) expense………………20,000……….30, 000………...…15,000 ... 65,000
Depreciation expense ……………………14,000 ……….14, 000 ……….14, 000 ……………42,000
Other expenses (3% of sales) …………….12, 000……….18, 000……………9, 000 ………….39, 000
Total operating expense budget……………143,000 ……159,000……….135, 000 ………….437, 000
f. Schedule of expected cash disbursements for operating expense
Aman Company
Schedule of expected cash disbursements for operating expense
For the quarter ended March 31, 2005
Months
…………January ……...February……. March ………Quarter
Salaries and wages ……………………….27, 000…………27,000…………27,000……….81, 000
Advertising expense …………………….70, 000……….70, 000………… 70,000 ………….210, 000
Shipping (5% sales) expense …………20, 000 30,000 …15,000… ……….65, 000
Other expenses (3% sales) …………….….12, 000……….18, 000 ……….9, 000 …….39, 000
Total cash disbursements for
Operating expense…………………...... 129,000……….145,000……121,000 ………….395,000

g. Budgeted income statement

Aman Company
Budgeted income statement
For the quarter ended, March 31, 2005
Sales…………………………………………………………………………...1, 300,000
Less: cost of goods sold ………………………………………………………780,000
Gross profit ……………………………………………………………………520,000
Less: operating expenses:
Salaries and wages……………………………………81,000
Advertising expense…………………………………...210,000
Shipping expense …………………………………….65, 000
Depreciation expense………………………………….42, 000
Other expenses………………………………………….39, 000
Total operating expenses……………………………………………………. ….. (437,000)
Net operating income ………………………………………………………………83,000
Less: interest expense …………………………………………………………………...2,400
Net income……………………………………………………………………………...80,600

Solution 2. Financial budget

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 a) Cash budget
Aman Company
Schedule of expected cash disbursements for operating expense
For the quarter ended, March 31, 2005
Months
…….. January …… February…… March………... Quarter
Cash balance beginning ………...48,000 ……30,000……….30, 800…………...48, 000
Add Receipts:
Collection from customers ……….304, 000………. 440,000 ……….540, 000…………1,284,000
Total cash available...…….………...352,000……….470, 000………. 570,000…………1,332,000
Less: disbursement:
Purchase of inventory …...……. 228,000 ………. 292,500 ………. .240,000 ……760,500
Operating expenses ……………129,000 ………. 145,000………. 121, 000……………395,000
Purchase of equipment ………. - ……….………….1, 700…………...84,500……………86,200
Cash dividend ……………45,000 ………. - ………. -……….………….….45, 000
Total disbursement … 402,000 …… .439, 200 ……….445, 500 ………….1, 286,700
Excess or deficiency of cash ………. (50,000) ……….30, 800…………125,300……………45,300
Financing:
Borrowing (at the beginning) ………...80,000 ……… - ………………. -………………...80,000
Payments (at the end) …...-………...-………………...…… (80,000) ………. (80,000)
Interest (at 12% per year) * ………... - ………... - ………... … (2,400) ………...... (2,400)
Total financing ………............... 80,000………... -……………………...82,400………..........2,400
Cash balance ending ………................30,000 ………...30,800………….42, 900 ………......42,900
*(Interest=80,000*12%/12) =800 per month. For three months=800*3=2400)
b) Budgeted balance sheet
Aman Company
Budgeted balance sheet
For the quarter ended, March 31, 2005
Asset
Current asset:
Cash ……………………………………………42,900
Account Receivable ………………………….240,000
Inventory ………………………………………30,000

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 Total current asset …………………………………………312, 900
Plant asset:
Building and equipment (net)……………………………...414, 200
Total assets………………………………………………….................727, 100
Liabilities and stockholders’ equity
Current liabilities:
Account payable …………………………………………82,500
Stockholders’ equity
Capital stock ……………………………………………...500,000
Retained earnings ………………………………………144, 600
Total Liabilities and stockholders’ equity……………………………...727,100
c) Budgeted statement of cash flows
Aman Company
Budgeted statement of cash flows
For the quarter ended, March 31, 2005
Cash flow from operating activities:
Cash collections from customers……………………….1, 284,000
Cash disbursement for purchase of inventory………… (760,500)
Cash disbursement for operating expenses…………… (397,500)
Net cash flow from operating activities………………………………128, 500
Cash flow from investing activity:
Cash out flow to purchase equipment…………………………………… (86,200)
Net cash flow from investing activity………………………………….. (86,200)
Cash flow from financing activities:
Cash disbursement for dividends ……………………….. (45,000)
Cash disbursement for interest expense………………….. (2,400)
Inflow from borrowing……………………………………80,000
Out flow for repayment…………………………………. (80,000)
Net cash flow from financing activities………………………………… (47, 400)
Net change in cash (deficit)………………………………………………... (5,100)
Plus: beginning cash balance…………………………………….…………………48,000
Ending: cash balance…………………………………………..………………….42,900

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2.5. DIFFICULTIES OF SALES FORECASTING
The usual starting point for the preparation of master budget is a sales revenue budget based on
forecasted sales of goods and services. The accuracy of the sales udder is critical because it acts
as the data source for all other budgets. If the sales figures are unreliable, the entire budget
process is a waste of time. Thus, it is easy to understand why every available effort is made to
obtain reliable estimates of projected sales. All companies have two things in common when it
comes to forecasting sales: sales forecasting is a critical step in the doubting process, and it is
very difficult to do it accurately. Sales forecasting is the process of predicting sales of goods or
services various procedures are used in sales forecasting, and the final forecast usually combines
information from many different sources. Though the marketing department normally
coordinates the effort to establish the sales forecast, many firms have a top-management-level
market research staff whose job is to coordinate the company’s sales forecasting efforts. A great
deal of effort general goes into the sales forecast, since it is such a critical step in the budget
process. A slightly inaccurate sales forecast, coming at the very beginning of the budget process,
will throw off all of the other schedules that make up the master budget. The tarring point in the
sales forecasting process is generally the sales level of the prior year. The following factors are
some of the major factors that must be taken into account at the time when sales are forecasted.
 Past sales levels and trends for the company that develops the forecast and for the entire
industry
 General economic trends (is the economy growing? How fast? Is economic recession or
slowdown expected?)
 Economic trends in the company’s industry (in the petroleum industry, for example, is
personal travel likely to increase, thereby implying increased demand for gasoline)
 Other factors expected to affect sales in the industry
 Political and legal events. (for example, changes in political power and legislations)
 The intended pricing policy of the company
 Planned advertising and product promotion
 Expected actions of competitors
 New product development (substitute or complement) by the company itself or other
firms
 Market research studies

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 Internal capacity and situation of the company.

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