lecture 6

5/26/2018 Lecture 6

1/25Leeds University Business School

Management Accounting

Lecture 6

Budgets for planning

Dr. Mohammad Alhadab

5/26/2018 Lecture 6


Aims and objectives

By the end of this lecture, you should be able to understand

the following:

The role of budgets in management accounting

Budgeting process

Purposes of budgets

Planning

Control

Motivation

Behavioural aspects of budgets Preparation of budgets

Example

5/26/2018 Lecture 6


Budgeting process

Co-ordinate various functions of the organisation via use of financial

plans: referred to as budgets

Co-ordinating process is referred to as the budgetary process

Definition

Preparation of a quantitative statement of expectations regarding theallocation of the organisation's resources

Objective

Provide a formal, quantitative & authoritative statement of the firm'splans

Main purposes of budgets are for planning, control & motivation But, may be conflicting objectives

Budgetary systems can & do influence behaviour & actions

But, not always in an anticipated or even desirable direction

5/26/2018 Lecture 6


Purposes of budgets

1. Plann ing Budgets represent financial expressions of formal plans - concerned

with the future

Budgets used to;

allocate resources

co-ordinate activities

communicate management plans to lower levels

2. Con tro l Essential that the outcomes are reported & monitored to ensure that

the objectives of the organisation are being met

Control systems Communications networks that monitor activities& provide basis for corrective action

Planned outputs compared with the actual results

identify deviationsvariance analysis

5/26/2018 Lecture 6

5/25

Leeds University Business School

Responsibility accounting

Managers held responsible only for those costs & revenues theycontrol

Guidelines

If can control quantity & price manager responsible for alltheexpenditure incurred.

If can control quantity, but not price manager responsible fordifference due to usage.

If expenditure is uncontrollablemanager should notbe responsible.

5/26/2018 Lecture 6

6/25


Purposes of budgets

3. Motivat ion

Budgetsstandards of achievement to which top management aspire

target to which managers may be motivated to strive to achieve

frequently used as a means of motivating individual managers &employees

5/26/2018 Lecture 6

7/25


Behavioural aspects of budgets

Use of budgets as a motivat ion target

Goal congruence

individuals internalise goals of organisation

satisfying own goals

satisfying organisations goals

Budgets do not motivation if individuals feel alienated from the goalsof the organisation

managers & employees should participate in the budget settingprocedure.

But - participation may allow individuals to incorporate bias into thebudget creating slack budgets.

5/26/2018 Lecture 6

8/25


Level of difficulty in attaining target

Past performance major factor in determining the abilityof the budget to motivate

Repeated failures to achieve a goal

individual lowers expectationsnegative effect on present & future performance

Success in meeting reasonable goals in the past

higher aspiration levels in the future & motivation

5/26/2018 Lecture 6

9/25


Conf l ic t ing ro les o f budget ing

Organisation rewards linked to managers budget record Manager's bonus or promotion prospects dependent on ability to meet

the budget targets used as a key motivating factor

But - accounting performance measures only approximate measures of

desired outcomes (Otley 1987)

Dysfunctional consequences If performance measures motivate managers to engage in behaviour not

in organisations best interest

lack of goal congruence

Actual behaviour may be affected so that the desired results are

reported, but achieved in undesirable ways which affect the firms longerterm performance

Many aspects of performance cannot be adequately measured inquantitative terms

5/26/2018 Lecture 6

10/25


Preparation of budgets

Production budget (in units)Sales in month X

Add: Closing stock of finished goods X

X

Less: Opening stock of finished goods (X)

Production in month X

Raw materials purchases budget

Materials required for production in month X

Add: Closing stocks at end of month XX

Less: Opening stocks at start of month (X)

Material purchases in the month X

5/26/2018 Lecture 6

11/25


Cash budget

Raw materials purchase payments budget

Materials purchases are not the same as cash payments

Need to consider the credit terms allowed

Other cash payments

Budgeted cash payments entered in the cash budget for themonth in which the payment is expected to occur

Exclude- non-cash costs such as depreciation

Include- cash payments for fixed assets

5/26/2018 Lecture 6

12/25


Cash budget

NB: Remember - accruals concept.

Sales Based on the number of units sold in the period

Not the cash received in respect of sales

Need to allow for any discounts given

Cost of goods sold Based on the sales in the period

Not on cash paid in respect of goods sold, nor on the productioncarried out in the period if stocks of finished goods are held

Other expenses Based on expenses incurred in the period

Not on cash payments made

5/26/2018 Lecture 6

13/25

ABC Ltd has just developed an entirely new product which does not fit in with its

existing range. It has therefore decided to set up A Ltd, as a wholly owned

subsidiary to produce and market this product. 750,000 is to be provided by ABC

LTD at the beginning of month 1 through an issue of ordinary shares in A Ltd; any

further finance required by A Ltd will also be provided by ABC Ltd in the form of an

interest-free fluctuating loan.

Plant for the new company, installed in rented premises, will cost 200,000 and be

completely written off over an estimated life of 5 years. It will be paid for at the

end of month 2.

Production will be so regulated, commencing in month 1, that the stock of finished

goods at the end of each month will be equal to the next two months budgeted

sales.

The first few monthssales are budgeted as follows:

Month 1 zero unitsMonth 2 20,000 units

Month 3 36,000 units

Month 4 54,000 units

and thereafter, at 50,000 units per month.

Normal annual production will 600,000 units (that is, 50,000 units per month).

Example - ABC LTD

5/26/2018 Lecture 6

14/25

One quarter of each monthssaleswill be for cash with the remaindersold on one

monthscredit. Selling price will be 10 per unit.

Budgeted product and administrative costs are as follows:Material 2 per unit

Labour and variable manufacturing

overheads 5 per unitAnnual fixed manufacturing overheads

(allocated to units output on the basisof normal annual production)

900,000 (including plant depreciation)

Annual selling and administrative

overheads (fixed) 760,000 Material purchases are made just before the end of each month in such a way

that the closing stock each month will exactly satisfy the next three monthsproduction requirements. A special purchase will be made at the beginning of

month 1 sufficient for the first three months production requirements.

Suppliers of material allow an average 1 monthscredit. Wages and variables

manufacturing overheads will be paid in the month in which they are incurred,

and all outlays on fixed overheads will be paid quarterly in advance.

Example - ABC LTD- continued

5/26/2018 Lecture 6

15/25


Required:

1. For each month of the first three months of A Ltdsoperations:

(a) Calculate the number of units of finished product produced.

5 marks

(b) Calculate the value of materials purchases and the amount paid to the suppliers

of material.

5 marks(c) Calculate the amount of cash received in respect of sales.

5 marks

(d) Prepare a cash budget including the payments made by, and to, the holding

company. 10 marks

2. Calculate the cost per unit based on normal production and prepare a budgetedProfit and Loss Account for As first quarter year and its budgeted Balance Sheet as at

the end of that period 45 marks

3. Comment briefly on A Ltdsprojected performance. 30 marks

Total 100 marks

Example - ABC LTD- continued

5/26/2018 Lecture 6

16/25


(a)- Production Budget (units)

Month 1 Month 2 Month 3 Month 4 Month 5

Sales 0 20,000 36,000 54,000 50,000

Closing Stock 56,000 90,000 104,000 100,000 100,000

Total 56,000 110,000 140,000 154,000 150,000

Less: Opening Stock 0 56,000 90,000 104,000 100,000

Production 56,000 54,000 50,000 50,000 50,000

(b)-Raw Material Purchases Budget ()


Materials Required 112,000 108,000 100,000 100,000 100,000

Closing Stock 308,000 300,000 300,000 300,000 300,000

Total 420,000 408,000 400,000 400,000 400,000

Less: Opening Stock 0 308,000 300,000 300,000 300,000

Purchases 420,000 100,000 100,000 100,000 100,000

ABC LTD- question 1 solutions

5/26/2018 Lecture 6

17/25

(b)- Purchases Payment Budget ()


Initial Purchases(for first three months 112+108+100) 320,000

Previous month's purchases 100,000 100,000 100,000 100,000

Total payment 420,000 100,000 100,000 100,000

(c)- Sales Receipt Budget ()


Sales Revenue

(10/unit) 200,000 360,000 540,000 500,000

Cash Sales (25%) 50,000 90,000 135,000 125,000

Debtors (75%) (1 Month credit) - 150,000 270,000 405,000

Sales Receipts: - 50,000 240,000 405,000 530,000


5/26/2018 Lecture 6

18/25

(d)- Cash Budget


Receipts:

Capital Issue 750,000 - - - -

Sales Revenue - 50,000 240,000 405,000 530,000

Total Receipts 750,000 50,000 240,000 405,000 530,000

Payments:

Plant - 200,000 - - -Purchases - 420,000 100,000 100,000 100,000

Labour (5 * units produced) 280,000 270,000 250,000 250,000 250,000

Fixed Manuf. OH 225,000 (150/600*900,000) see note (1) at the end

Fixed Adm&Sales OH 190,000 (760,000/4)

Less: Depreciation - (10,000) (200,000/5/4) see note (2) at the endTotal Payments 685,000 890,000 350,000 350,000 350,000

Cash Surplus/ Deficit 65,000 -840,000 -110,000 55,000 180,000

Opening Balance - 65,000 - - -

Borrowing - 775,000 110,000 - -


5/26/2018 Lecture 6

19/25

Cost Per Unit

Materials 2.00

Labour 5.00

Manuf OH (900,000 / 600,000) 1.50

Total Cost / Unit 8.50

Budgeted P& L Account

1st Quarter

Sales (20,000 month 1 2 sales + 36,000 month 2 3 sales) 560,000

Less: Cost of goods sold (20,000+36,000 ) * 8.5 (see cost per unit above) 476,000

Gross Profit: 84,000

Less: Selling & Admin (760,000 / 4 quarters) 190,000

Overabsorbed Fixed Manuf OH see note (3) at the end -15,000 175,000

Net Loss: -91,000

ABC LTD- question2 solutions

E l ABC LTD 2 l ti

5/26/2018 Lecture 6

20/25

Budgeted Balance Sheet

Fixed Assets:

Plant: Cost of Purchase 200,000

Less: Depreciation 10,000 190,000

Current Assets:

Stocks:

Finished Goods (104,000 units from Prod Bud x 8.5) 884,000

Raw Materials (from Raw Material Budget) 300,000 1,184,000

Debtors (from Sales Receipt Budget) 270,000

1,454,000

Less: Current Liabilities

Creditors (from Purchases Payment Budget) 100,000

Loan from ABC LTD ( from Cash Budget 775,000+110,000) 885,000 985,000

469,000

Total Assets: 659,000

Represented by:

Share Capital 750,000

Less: Net Loss 91,000

659,000

Example - ABC LTD- 2 solutions

5/26/2018 Lecture 6

21/25


Normal Budgeted P& L Account

1st Year

Sales (600,000 units* 10) 6,000,000

Less: Cost of Goods Sold (600,000 units* 8.5) 5,100,000

Gross Profit: 900,000

Less: Selling & Adminstrative Costs 760,000Net Profit (EBITDA) 140,000

'Normal' return on equity capital = (140/750) = 18.66%

However:

1. Ignores 'start-up' performance and initial borrowing.

2. Ignores inflation or specific increases in costs.

3. Ignores possible future demand changes with effects on selling price.

4. Need data covering a longer time period to complete an estimated discounted cash

flow analysis.


5/26/2018 Lecture 6

22/25


Notes:

Note (1)-How to calculate fixed manufacture overhead (Fixed Manuf. OH) for the first

three months?

- It is indicated in the question that the annual fixed manufacturing overheads are

allocated to units output on the basis of normal annual production.

-Also, as indicated in the question, the normal annual production will 600,000 units

(that is, 50,000 units per month).

So, the annual fixed manufacturing overheadsto the first three months should as

follows

Fixed Manuf. OH for the first three months = (150,000 / 600,000 ) X 900,000

= 220,000 225,000150,000 = 50,000 X 3 months

600,000 = 50,000 X 12 months

5/26/2018 Lecture 6

23/25


ABC LTD-

Note (2)-

How to calculate annual depreciation for fixed assets?

Annual Depreciation = cost of assets / life of assets

= 200,000 / 5 years

= 40,000But the question requires to prepare the cash budget for the first three months

of the year (1stquarter). Thus, we divide the annual depreciation by 4 (each

year has 4 quarters).

Depreciation for the first three months (1stquarter) = 40,000 / 4

=10,000

Or you can divide the annual depreciation by 12 months and then times 4 as

follows 40,000 / 12months= 3,333.33

Then 3,333.33 X 3 months = 10,000

5/26/2018 Lecture 6

24/25


Note (3)-

How to calculate Overabsorbed Fixed Manuf OH ?

Overabsorbed Fixed Manufacturing Overheads=

(Production in first three months -normal production )* fixed overheads per unit

Production in first three months = 56,000 + 54,000 + 50,000 units

=160,000 units

Normal production = 600,000 units / 4 = 150,000 units

Fixed overhead per unit = 900,000 / 600,000 units= 1.5

Overabsorbed Fixed Manuf OH = (160,000150,000) * 1.50

= 15,000

5/26/2018 Lecture 6

25/25


Recommended reading:

Chapter 13, Weetman

lecture 6

Documents

future budgets

role of budgets

slack budgets

budgets coordinating

plann ing budgets

management plans

notbe responsible

management aspiretarget