Budgetary Control and Activity Based Costing

Dr Pawan Gupta

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.

Budgetary Control

Budgetary Control Reporting System

Name of Report
Sales Labor

Frequency
Weekly Weekly

Purpose

Primary Recipient(s)

Scrap

Daily

Department Monthly Overhead costs Selling expenses Monthly Income Statement Monthly and quarterly

Determine whether sales Top management and sales goals are being met manager Control direct and indirect Vice president of production labor costs and production department managers Determine efficient use of Production manager materials Control overhead costs Department manager Control selling expenses Determine whether income objectives are being met Sales manager Top manager

 TYPES OF BUDGETS

The overall budget is known as the master budget. A master budget normally consists of three types of budgets:

(i) Operating Budgets (ii) Financial Budgets

(iii) Special Decision Budgets

1. Operating Budget
Operating budgets relate to physical activities/ operations such as sales, production, and so on. Operating budget has the following components Sales budget, Production budget, Purchase budget, Direct labour budget, Manufacturing expenses budget, and Administrative and selling expenses budget, and so on.

1) 2) 3) 4) 5) 6)

 2. Financial Budget

Financial budgets are concerned with expected cash flows, financial position and result of operations. Financial budget has the following components 1) 2) 3) 4) Budgeted income statement, Budgeted statement of retained earnings, Cash budget, and Budgeted balance sheet.

 Cash Budget
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 planning period. The principal aim of the cash budget, 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.

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

 Operating Cash Flow

The main operating factors/items which generate cash outlfows and inflows over the time span of a cash budget are tabulated in Exhibit 1.
Exhibit 1. Operating Cash Flow Items Cash 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

 Financial Cash Flow Items

The major financial factors/items affecting generation of cash flows are depicted in Exhibit 2.
Exhibit 2. Financial Cash Flow Items Cash inflows/Receipts Cash outflows/Payments

1. 2. 3. 4. 5. 6. 7.

Loans/borrowings Sale of securities Interest received Dividend received Rent received Refund of tax Issues of new shares and securities

1. 2. 3. 4. 5.

Income tax/tax payments Redemption of loan Re-purchase of shares Interest paid Dividends paid

Example 1 The following data relate to Hypothetical Limited: Balance Sheet as at March 31, Current Year Liabilities Accounts payable (all for March purchases) Taxes payable (all for March income) Share capital Retained earnings Amount Assets Rs 40,000 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) Amount Rs 3,00,000 2,50,000 28,800

25,000 11,00,000 10,26,800

63,000

_______ 21,91,800

15,50,000 21,91,800

2. Sales forecasts: Assume the marketing department has developed the following sales forecast for the first quarter of the next year and the selling price of Rs 50 per unit. Month Units sales

April May June

9,000 12,000 16,000

3. The management desires closing inventory to equal 20 per cent of the following months sales.
4. The manufacturing costs are as follows Direct 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 costing basis. 6. Each unit of final product requires 5 kgs of raw materials. Assume management desires closing raw material inventory to equal 20 per cent of the following months requirements of production.

7. Assume fixed selling and administrative expenses are Rs 20,000 per month and variable selling and administrative expenses are Rs 5 per unit sold. 8. All sales are on account. Payment received within 10 days from the date of 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 are collected during the following month. Of collections during the month of sale, 50 per cent are collected during the discount period. Accounts receivable are recorded at the gross amount and cash discounts are treated as a reduction in arriving at net sales during the month they are taken. 9. Tax rate is 35 per cent. 10. Additional information: (a) All purchases are on account. Two-thirds are paid for in the month of purchase and one-third, in the following month. (b) Fixed manufacturing costs include depreciation of Rs 20,000 per month. (c) Taxes are paid in the following month. (d) All other costs and/or expenses are paid during the month in which incurred. From the foregoing information prepare a master budget for the month of April only.

Solution 1.Production Budget Particulars Sales (units) Add: Desired closing inventory (0.20 next months sales) Total finished goods requirement Less: Opening inventory Required production (units) April 9,000 2,400 11,400 (1,800) 9,600 May 12,000 3,200 15,200 (2,400) 12,800 April 9,600 Rs 15 Rs 1,44,000 48,000 86,400 2,78,400 60,000 3,38,400

2.Manufacturing Cost Budget

Particulars 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

3.Purchase Budget (Raw Materials) Particulars 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) 4.Selling and Administrative Expenses Budget Particulars Units sales Variable costs @ Rs 5 per unit Fixed costs Total selling and administrative expenses April 9,000 Rs 45,000 20,000 65,000 April 9,600 ______ 48,000 12,800 60,800 (9,600) 51,200 Rs 1,53,600 May 12,800 _____ 64,000

5. Cost of Goods Sold Budget Particulars Units sold Cost per unit Variable Fixed (Rs 60,000 10,000 units) Total cost 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 expenses Earnings before taxes Less: Taxes (0.35) Earning after taxes Rs 4,50,000 2,700 4,47,300 3,15,000 1,32,300 2,400 1,29,900 65,000 64,900 22,715 42,185 April 9,000 Rs 29 6

Rs 35 3,15,000

7.Budgeted Statement of Retained Earnings Opening balance Add: Earnings after taxes Closing balance 8.Cash Budget (April) Opening balance Cash inflows: Collection from debtors: March sales April sales (gross) (Rs 4,50,000 0.60) Rs 2,70,000 Less: Cash discount (Rs 2,70,000 0.5 0.02) 2,700 Cash outflows: Payment to creditors: For March purchases For April purchases (Rs 1,53,600 2/3) Direct labour Variable manufacturing overhead Fixed manufacturing overhead Less: Depreciation Variable selling and administrative overheads Fixed selling and administrative overheads Taxes Closing balance

Rs 10,26,800 42,185 10,68,985

Rs 3,00,000
Rs 2,50,000

2,67,300
40,000 1,02,400

5,17,300

Rs 8,17,300

1,42,400 48,000 86,400 40,000 45,000 20,000 25,000

60,000 (20,000)

4,06,800 4,10,500

9. Proforma Balance Sheet as at March 31, Next Year Liabilities Accounts payable (Rs 40,000 + Amount Assets Cash Accounts receivable Amount Rs 4,10,500

Rs 1,53,600
Rs 1,42,400) Taxes payable (Rs 25,000 + Rs 22,715 Rs 25,000) 22,715

(Rs 4,50,000 0.40)

Rs 51,200 Inventories: Raw material (12,800 Rs 3) Finished goods Rs 38,400

1,80,000

Share capital
Retained earnings

11,00,000

(2,400 Rs 35)
Cost Less: Accumulated

84,000
20,00,000 (4,70,000)

1,22,400

10,68,985 Fixed assets:

________ 22,42,900

depreciation

15,30,000 22,42,900

 Special Decision Budgets

The third category of budgets are special decision budgets. They relate to inventory levels, break-even analysis, and so on.

Fixed and Flexible 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

 Flexible Budgets
The term flexible is an apt description of the essential features of these budgets. A flexible budget estimates costs at several levels of activity. Its merit is that instead of one estimate, it contains several estimates/plans in different assumed circumstances. It is a useful tool in real world situations, that is, unpredictable environment.

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

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

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

Table 1 Hypothetical LtdFlexible Budget (Maintenance Department)

Volume (labour-hours)
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

4,000
Rs 6,000 2,400 800 2,300 1,400 2,500 1,500 3,500 5,000 3,500 28,900

4,500
Rs 6,750 2,700 900 2,400 1,450 2,750 2,000 4,000 5,000 3,500 31,450

5,000
Rs 7,500 3,000 1,000 2,500 1,500 3,000 2,000 4,000 5,000 3,500 33,000

5,500
Rs 8,250 3,300 1,100 2,600 1,550 3,250 2,000 4,000 5,000 3,500 34,550

6,000
Rs 9,000 3,600 1,200 2,700 1,600 3,500 2,500 4,500 5,000 3,500 37,100

Table 2: Hypothetical LtdFlexible Budget (Manufacturing Department) Volume (machine-hours) 50 60 70 80 90

Variable costs:
Power Helpers Discretionary fixed costs: Training Tools Committed fixed costs: Depreciation Rent Total 1,200 1,000 3,950 1,200 1,000 4,200 1,200 1,000 4,350 1,200 1,000 4,600 1,200 1,000 4,850 800 200 900 200 900 200 900 300 1,000 300 Rs 500 250 Rs 600 300 Rs 700 350 Rs 800 400 Rs 900 450

 Modified Flexible Budgets

Flexible budgets, as a tool of planning and control, are superior to fixed budgets. The major weaknesses of fixed 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. Limitations Flexible 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.

Table 3: Hypothetical Department) Volume (labour-hours) Variable costs: Labour Materials Others Mixed costs: Labour Maintenance Other supplies Discretionary fixed costs: Training Experimental methods Committed fixed costs: Depreciation Rent, etc. Total

LtdModified

Flexible

Budget

(Manufacturing Optimistic

Pessimistic Most likely 4,250 Rs 6,375 2,650 850 5,000 Rs 7,500 3,000 1,000

5,850 Rs 8,775 3,510 1,170

2,350 1,425 2,625

1,750 3,750 5,000 3,500 30,275

2,500 1,500 3,000

2,000 4,000 5,000 3,500 33,000

3,425 1,585 2,670

2,250 4,250 5,000 3,500 36,135

Activity-Based Costing

Costing Products...
Direct materials and direct labor costs are easy to trace Overhead cannot be traced easily and must be assigned with estimates

Traditional Costing Methods...

Spreads overhead cost over entire customer base Each order appears to cost the same Orders with high profit margins subsidize orders with low profit margins

Traditional Costing Methods...

A single or plantwide rate called a predetermined overhead rate is used:
Job Order = Direct Labor Costs Process Cost = Machine Hours

Need for a New System Amount of direct labor used in many industries has decreased Total overhead from depreciation on equipment, utilities, repairs, maintenance has increased

Activity-Based Costing (ABC)

An overhead cost allocation system that allocates overhead to multiple activity cost pools and assigns the activity cost pools to products or services by means of cost drivers that represent the activities used.

Activity
Any event, action, transaction, or work sequence that causes a cost to be incurred in producing a product or providing a service.

Activity Cost Pool The overhead cost allocated to a distinct type of activity or related activities.

Illustration 4-2

Activities and Related Cost Drivers

Reasoning for ABC

Cost Driver
Any factor or activity that has a direct cause-effect relationship with the resources consumed. In ABC cost drivers are used to assign activity cost pools to products or services.

Illustration 4-3

Activity-Based Costing (ABC)

Calculate unit cost Identify activities Identify cost driver Compute overhead rate Assign overhead costs

Benefits of Activity-Based Costing

More accurate product costing which necessitates:

More cost pools used to assign overhead Enhanced control over overhead Better management decisions

Limitations of Activity-Based Costing

Can be expensive to use. Some arbitrary allocations continue.

Switch to ABC when...

Products differ greatly in volume and manufacturing complexity Products lines are numerous diverse require differing degrees of support services Overhead costs constitute a significant portion of total costs The manufacturing process or number of products has changed significantly Production or marketing managers are ignoring data provided existing system