budgetery control & abc

7/30/2019 Budgetery Control & ABC

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Budgetary Control and

Activity Based Costing

Dr Pawan Gupta


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Budgetary Control

One of the main functions of management is

to control.

Budgets are useful in controlling operations.

The use of budgets to control operations.

Compare actual results with planned

objectives.


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Budgetary Control


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Name of

Report

Frequency Purpose Primary Recipient(s)

Sales Weekly Determine whether sales

goals are being met

Top management and sales

manager

Labor Weekly Control direct and indirect

labor costs

Vice president of production

and production department

managers

Scrap Daily Determine efficient use of

materials

Production manager

Department

Overhead costs

Monthly Control overhead costs Department manager

Selling expenses Monthly Control selling expenses Sales manager

Income

Statement

Monthly

and

quarterly

Determine whether

income objectives are

being met

Top manager

Budgetary Control Reporting System


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TYPES OF BUDGETS

The overall budget is known as the master budget. A masterbudget normally consists of three

types of budgets:

(i) Operating Budgets

(ii) Financial Budgets

(iii) Special Decision Budgets


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1. Operating Budget

1) Sales budget,

2) Production budget,

3) Purchase budget,

4) Direct labour budget,

5) Manufacturing expenses budget, and

6) Administrative and selling expenses budget, and so on.

Operating budgets relate to physical activities/ operationssuch as sales, production,

and so on.

Operating budget has the following components


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2. Financial Budget

1) Budgeted income statement,

2) Budgeted statement of retained earnings,3) Cash budget, and

4) Budgeted balance sheet.

Financial budgets are concerned with expected cashflows, financial position and

result of operations.

Financial budget has the following components


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Cash Budget

The preparation of a cash budget involves several steps.

The first element of a cash budget is the selection of the period of

the budget, that is, the planning horizon.

The second element of the cash budget is the selection/identification

of the factors that have a bearing on cash flows.The factors that generate cash are generally divided into two broad

categories:

(i) Operating (ii) Financial

Cash budget is a device to help a firm to plan for and control the use of cash. It is a

statement showing the estimated cash inflows and cash outflows over the planningperiod. The principal aim of the cashbudget, as a tool to predict cash flows over a period of time,is to ascertain whether there is likely to be excess/shortage of cash at any time.


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Operating Cash Flow

Exhibit 1. Operating Cash Flow ItemsCash inflows/Receipts Cash outflows/Disbursements

1. Cash sales

2. Collection of accounts

receivable

3. Disposal of fixed assets

1. Accounts payable/Payable payments

2. Purchase of raw materials

3. Wages and salary (pay roll)

4. Factory expenses

5. Administrative and selling expenses

6. Maintenance expenses

7. Purchase of fixed assets

The main operating factors/items which generate cashoutlfows and inflows over the time span of a

cash budget are tabulated in Exhibit 1.


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Financial Cash Flow Items

The major financial factors/items affecting generation ofcash flows are depicted in Exhibit 2.

Exhibit 2. Financial Cash Flow Items

Cash inflows/Receipts Cash outflows/Payments

1. Loans/borrowings

2. Sale of securities

3. Interest received

4. Dividend received

5. Rent received

6. Refund of tax

7. Issues of new shares and securities

1. Income tax/tax payments

2. Redemption of loan

3. Re-purchase of shares

4. Interest paid

5. Dividends paid


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Example 1

The following data relate to Hypothetical Limited:

Balance Sheet as at March 31, Current Year

Liabilities Amount Assets Amount

Accounts payable

(all for March purchases)

Taxes payable

(all for March income)

Share capitalRetained earnings

Rs 40,000

25,000

11,00,00010,26,800

_______

21,91,800

Cash

Accounts receivable

(all from March sales)

Inventories:

Raw materials (9,600 kgs Rs 3)Finished goods

(1,800 units Rs 35)

Fixed assets:

Cost Rs 20,00,000

Less: Accumulated

depreciation (4,50,000)

Rs 3,00,000

2,50,000

28,800

63,000

15,50,000

21,91,800


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2. Sales forecasts: Assume the marketing department has developed thefollowing sales forecast for the first quarter of the next year and the sellingprice of Rs 50 per unit.

Month Units sales

AprilMay

June

9,00012,000

16,000

3. The management desires closing inventory to equal 20 per cent of thefollowing months sales.

4. The manufacturing costs are as followsDirect materials: (5 kgs Rs 3) (per unit)

Direct labour

Variable overheads

Total fixed overheads (per annum)

Rs 15

5

9

7,20,000

5. Normal capacity is 1,20,000 units per annum. Assume absorption costingbasis.

6. Each unit of final product requires 5 kgs of raw materials. Assumemanagement desires closing raw material inventory to equal 20 per centof the following months requirements of production.


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7. Assume fixed selling and administrative expenses are Rs 20,000 permonth and variable selling and administrative expenses are Rs 5 perunit sold.

8. All sales are on account. Payment received within 10 days from the dateof sale are subject to a 2 per cent cash discount. In the past, 60 per cent

of the sales were collected during the month of sale and 40 per cent arecollected during the following month. Of collections during the month ofsale, 50 per cent are collected during the discount period. Accountsreceivable are recorded at the gross amount and cash discounts aretreated as a reduction in arriving at net sales during the month they aretaken.

9. Tax rate is 35 per cent.10. Additional information:

(a) All purchases are on account. Two-thirds are paid for in the monthof purchase and one-third, in the following month.

(b) Fixed manufacturing costs include depreciation of Rs 20,000 permonth.

(c) Taxes are paid in the following month.

(d) All other costs and/or expenses are paid during the month in whichincurred.

From the foregoing information prepare a master budget for the month ofApril only.


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Solution

1.Production Budget

Particulars April May

Sales (units)Add: Desired closing inventory (0.20 next months sales)

Total finished goods requirement

Less: Opening inventory

Required production (units)

9,0002,400

11,400

(1,800)

9,600

12,0003,200

15,200

(2,400)

12,800

2.Manufacturing Cost BudgetParticulars April

Required production (units)

Direct material cost (5 kgs Rs 3 per kg)

Total direct material cost

Total direct labour cost (Rs 5 per unit)Total variable overhead cost (Rs 9 per unit)

Total variable manufacturing costs

All fixed manufacturing overheads (Rs 7,20,000 12 months)

Total manufacturing cost

9,600

Rs 15

Rs 1,44,000

48,00086,400

2,78,400

60,000

3,38,400


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3.Purchase Budget (Raw Materials)

Particulars April May

Production requirement (units)

Raw material required for production @ 5 kgs per unit(kgs)

Add: Desired closing inventory (0.20 May

requirements)

Total requirements

Less: Opening inventory

Purchase requirement

Purchase requirement (amount @ Rs 3 per kg)

9,600

______48,000

12,800

60,800

(9,600)51,200

Rs 1,53,600

12,800

_____64,000

4.Selling and Administrative Expenses Budget

Particulars April

Units salesVariable costs @ Rs 5 per unit

Fixed costs

Total selling and administrative expenses

9,000Rs 45,000

20,000

65,000


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5. Cost of Goods Sold Budget

Particulars April

Units sold

Cost per unit

VariableFixed (Rs 60,000 10,000 units)

Total cost

Rs 296

9,000

Rs 35

3,15,000

6. Budgeted Income Statement for the Month of April

Gross sales (9,000 Rs 50)

Less: Cash discount (Rs 4,50,000 0.6 0.5 0.02)Net sales

Less: Cost of goods sold

Gross margin (unadjusted)

Less: Capacity variance unfavourable (400 units Rs 6)

Gross margin (adjusted)

Less: Selling and administrative expensesEarnings before taxes

Less: Taxes (0.35)

Earning after taxes

Rs 4,50,000

2,7004,47,300

3,15,000

1,32,300

2,400

1,29,900

65,00064,900

22,715

42,185


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7.Budgeted Statement of Retained Earnings

Opening balanceAdd:Earnings after taxesClosing balance

Rs 10,26,80042,185

10,68,985

8.Cash Budget (April)

Opening balanceCash inflows:Collection from debtors:March salesApril sales (gross) (Rs 4,50,000 0.60)Less:Cash discount(Rs 2,70,000 0.5 0.02)

Cash outflows:Payment to creditors:For March purchasesFor April purchases (Rs 1,53,600

2/3)Direct labourVariable manufacturing overheadFixed manufacturing overheadLess:DepreciationVariable selling and administrativeoverheadsFixed selling and administrativeoverheadsTaxesClosing balance

Rs 2,70,000

2,700

Rs 2,50,000

2,67,300

40,000

1,02,400

60,000(20,000)

Rs 3,00,000

5,17,300

1,42,40048,00086,400

40,00045,000

20,00025,000

Rs 8,17,300

4,06,8004,10,500


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9. Proforma Balance Sheet as at March 31, Next Year

Liabilities Amount Assets Amount

Accounts payable

(Rs 40,000 +Rs 1,53,600

Rs 1,42,400)

Taxes payable

(Rs 25,000 + Rs 22,715

Rs 25,000)

Share capital

Retained earnings

Rs 51,200

22,715

11,00,000

10,68,985

________

22,42,900

Cash

Accounts receivable(Rs 4,50,000 0.40)

Inventories:

Raw material

(12,800 Rs 3)

Finished goods

(2,400 Rs 35)

Fixed assets:

Cost

Less: Accumulated

depreciation

Rs 38,400

84,000

20,00,000

(4,70,000)

Rs 4,10,500

1,80,000

1,22,400

15,30,000

22,42,900


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Special Decision Budgets

Fixed Budgets

Budgets prepared at a single level of activity, with no prospect of

modification in the light of changed circumstances, are referred to

as fixed budgets.

Flexible Budgets

The alternative to fixed budgets are flexible/variable/sliding

budgets

The third category of budgets are special decisionbudgets. They relate to inventory levels, break-even

analysis, and so on.

Fixed and Flexible Budgets


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Flexible Budgets

The term flexible is an apt description of the essential features ofthese budgets. A flexible budget estimates costs at several levels ofactivity.

Its merit is that instead of one estimate, it contains severalestimates/plans in different assumed circumstances. Itis a useful tool in real world situations, that is, unpredictableenvironment.

A flexible budget, in a sense, is a series of fixed budgets and anyincrease/decrease in the level/volume of activity must be reflected init.


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Each expense in each department/segment is to be categorisedinto fixed, variable and mixed components. A budget may firstbe prepared at the expected level of activity, say, 100 per centcapacity. Additionalcolumns may then be added for costs below and above, 90 percent and 110 per cent capacity and so on.

The conceptual framework of flexible budgeting relates to: (i)Measure of volume and (ii) Cost behaviour with change in

volume


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Table 1 Hypothetical LtdFlexible Budget (Maintenance Department)

Volume (labour-hours) 4,000 4,500 5,000 5,500 6,000

Variable costs:

Labour

Material

Others

Mixed costs:

Labour

Maintenance

Other supplies

Discretionary fixed costs:

Training

Experimental methods

Committed fixed costs:

Depreciation

Rent, lease cost

Total

Rs 6,000

2,400

800

2,300

1,400

2,500

1,500

3,500

5,000

3,500

28,900

Rs 6,750

2,700

900

2,400

1,450

2,750

2,000

4,000

5,000

3,500

31,450

Rs 7,500

3,000

1,000

2,500

1,500

3,000

2,000

4,000

5,000

3,500

33,000

Rs 8,250

3,300

1,100

2,600

1,550

3,250

2,000

4,000

5,000

3,500

34,550

Rs 9,000

3,600

1,200

2,700

1,600

3,500

2,500

4,500

5,000

3,500

37,100


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Table 2: Hypothetical LtdFlexible Budget (Manufacturing Department)

Volume (machine-hours) 50 60 70 80 90

Variable costs:

Power

Helpers


Training

Tools


Depreciation

Rent

Total

Rs 500

250

800

200

1,200

1,000

3,950

Rs 600

300

900

200

1,200

1,000

4,200

Rs 700

350

900

200

1,200

1,000

4,350

Rs 800

400

900

300

1,200

1,000

4,600

Rs 900

450

1,000

300

1,200

1,000

4,850


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Modified Flexible Budgets

Flexible budgets, as a tool of planning and control, are superior

to fixed budgets.

The major weaknesses offixed budgets are their inability to:

(i) Show the potential variability of various estimates used in the

preparation of the budget, and

(ii) Indicate the range within which costs may be expected to vary. They

are, therefore, not useful in an uncertain and unpredictable environment.

Flexible budgets present estimates at different levels of activity, and are

more useful.

LimitationsFlexible budgets suffer from one limitation in that they do not explicitly

consider the relative probability of a particular volume/cost being

achieved. This limitation can be overcome by using a modified

flexible budget which will include columns for different levels

of estimates: most likely, optimistic and pessimistic.


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Table 3: Hypothetical LtdModified Flexible Budget (Manufacturing

Department)

Pessimistic Most likely Optimistic

Volume (labour-hours) 4,250 5,000 5,850Variable costs:

Labour

Materials

Others

Mixed costs:Labour

Maintenance

Other supplies


Training

Experimental methods


Depreciation

Rent, etc.

Total

Rs 6,375

2,650

850

2,350

1,425

2,625

1,750

3,750

5,000

3,500

30,275

Rs 7,500

3,000

1,000

2,500

1,500

3,000

2,000

4,000

5,000

3,500

33,000

Rs 8,775

3,510

1,170

3,425

1,585

2,670

2,250

4,250

5,000

3,500

36,135


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Activity-Based Costing


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Costing Products...

Direct materials and directlabor costs are easy to trace

Overhead cannot be traced

easily and must be assignedwith estimates


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Traditional Costing Methods...

Spreads overhead cost overentire customer base

Each order appears to cost

the same

Orders with high profit

margins subsidize orders withlow profit margins


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Traditional Costing Methods...

A single or plantwide rate calleda predetermined overhead rate

is used:

Job Order = Direct Labor Costs

Process Cost = Machine Hours


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Need for a New System

Amount of direct labor used inmany industries has decreased

Total overhead from

depreciation on equipment,utilities, repairs, maintenancehas increased


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Activity-Based Costing (ABC)

An overhead cost allocationsystem that allocates overhead

to multiple activity cost pools

and assigns the activity costpools to products or services

by means of cost drivers that

represent the activities used.


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Activity

Any event, action, transaction,or work sequence that causes a

cost to be incurred in

producing a product orproviding a service.


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Activity Cost Pool

The overhead cost allocated toa distinct type of activity or

related activities.

Illustration 4-2


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Activities and Related Cost Drivers


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Reasoning for ABC


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Cost Driver

Any factor or activity that has adirect cause-effect relationship

with the resources consumed.

In ABC cost drivers are used toassign activity cost pools to

products or services.

Illustration 4-3


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Activity-Based Costing (ABC)

Calculate unit cost Identify activities

Identify cost driver

Compute overhead rate

Assign overhead costs


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Benefits of Activity-Based Costing

More accurate product costingwhich necessitates:

More cost pools used to

assign overhead

Enhanced control over

overheadBetter managementdecisions


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Limitations of Activity-Based Costing

Can be expensive to use.

Some arbitrary allocationscontinue.


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Switch to ABC when...

Products differ greatly in volume and

manufacturing complexityProducts lines arenumerousdiverse

require differing degrees of supportservicesOverhead costs constitute a significant

portion of total costsThe manufacturing process or number

of products has changed significantlyProduction or marketing managers are

ignoring data provided existing system

budgetery control & abc

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