MA - Budgeting

Introduction to Budgeting

DEFINITIONS:

Budgeting - future plan of expected revenues and expenditures for a budget period.

Budget period - specified period for which future plan is written.

Budget time specifications:

1) Prepared during planning stage of planning and control cycle;

2) Prepared before budgeting period starts;
3) Variances (differences between actual results and budget) are calculated at the control stage of planning
and control cycle.

Planning stage components:

Importance of budgeting:

- Estimation of revenues from product and services in the future period;

- Planning of spending generated revenue.

Types of budget:
a) Sales budget;
b) Production budgets;
c) Materials budgets;
d) Labour budgets;
e) Overheads budgets;
f) CAPEX budgets;
g) Master budgets:
- Cash budget;
- Budgeted statement of profit or loss;
- Budgeted statement of financial position.

STAGES IN THE BUDGET SETTING PROCESS:

1) Identify any limiting factors or principal budgeting factor;

2) Prepare individual budgets;
3) Review individual budgets;
4) Revise individual budgets where required;
5) Agree final individual budgets;
6) Prepare budgeted statement of profit or loss;
7) Prepare cash budget;
8) Prepare budgeted statement of financial position;
9) Prepare master budget;
10) Compare actual and budgeted results (variances).

BUDGET COMMITTEE:

The formation of a budget committee is important for budget preparation.

Budget committee responsibilities:

- Preparing the budget manual;

- Coordinating the budgeting process;
- Approval of individual budgets.

Members of the budget committee:

- Chairman;
- Budget officer;
- Budget managers;
- Member of finance department.

Budget manual - reference manual which sets out recommended procedures to follow in the budget-setting
process. Budget manual includes guidance on individual budget preparation and provides relevant forms.
 MA - Budgeting
Sales and Production Budgets

DEFINITIONS:

Limiting budget factor (or principal budget factor) - factor which limits a company’s activity levels, for example,
sales as demand is limited. A budget based on a limiting factor must be prepared first and influences all other
budgets.

SALES BUDGET:

Sales budget = Budgeted sales in units x Budgeted selling price

PRODUCTION BUDGET:

Description Units
Material usage budget (or budgeted sales in units) x
Add: Closing inventory* x
Less: Opening inventory* (x)
Production budget in units X

*Information regarding the opening and closing inventory may be given in the question, or may be required to
calculate it.

Budgets, which can be prepared with use of a production budget:

● Materials budget
● Labour budget
● Overhead budget

EXAMPLES:
Example 1:

Product X is the only product manufactured by Y Company. In Year 2, Y Company expects to sell 2,000 units of
Product X at a selling price of $150 per unit. Calculate the sales budget.

Solution:

Sales budget = Budgeted sales in unit x Budgeted selling price

Sales budget = 2,000 x $150

Sales budget = $300,000

Example 2:

Product H is the only product manufactured by K Company. In Year 2, K Company expects to sell 2,000 units of
Product H. There are 200 units of opening inventory and K Company wishes to have 300 units of closing
inventory at the end of the year. Calculate the budgeted production units.

Solution:

Description Units
Budgeted sales 2,000
Add: Closing inventory 300
Less: Opening inventory (200)
Production budget in units 2,100
 MA - Budgeting
Materials and Labour Budgets

MATERIAL BUDGETS:

There are two types of materials budget:

● Materials usage budget

● Materials purchase budget

Materials usage Budgeted production Quantity of material to make Standard

= x x
budget in $ in units one unit of product* cost*

Materials purchases budget:

Description Units of material

Material usage budget x
Closing inventory x
Less opening inventory (x)
Material purchases budget X

Cost of material purchase in $ = Material purchases budget x Standard cost*

LABOUR BUDGETS:

Labour budget Budgeted production Hours to make one Standard labour

= x x
in $ in units unit of product* rate per hour*

Note: Amounts with asterisk should be taken from the standard cost card.

EXAMPLE:
The standard cost card for Product X is as follows:

Cost $

Direct materials - 4 kg of Material B @ $10 per kg 40

Direct labour - 2 hours @ $6 per hour 12

Variable production overheads 2

Fixed production overheads 4

Total absorption cost 58

The business has budgeted to produce 1,800 units of Product X. The opening and closing stock of Material B
are expected to be 400 and 500 respectively.

Calculate the following:

● Materials usage budget in $

● Materials purchase budget in $
● Labour budget in $

Solution:

Materials usage budget in kg = $1,800 x 4 = 7,200 kg

Materials usage budget in $ = 7,200 x 10 = $72,000

Materials purchase budget in kg = 7,200 + 500 - 400 = 7,300 kg

Materials purchase budget in $ = 7,300 x 10 = $73,000

Labour budget in hours = 1,800 x 2 = 3,600

Labour budget in $ = 3,600 x $6 = $21,600
 MA - Budgeting
Overheads Budgets

VARIABLE PRODUCTION OVERHEADS BUDGET:

Variable production overheads budget - expected variable production overheads expenditure, when the
budgeted production volume is manufactured.

Standard variable production

Budgeted labour hours/
Variable production overhead rate per labour hours /
= machine hours / other x
overheads budget machine hour / other allocation
allocation basis
basis

FIXED PRODUCTION OVERHEADS BUDGET:

Fixed production overheads budget - expected expenditure on fixed production overheads, when the
budgeted production volume is manufactured.

Standard fixed production

Budgeted labour hours/
Fixed production overheads rate per labour hours /
= machine hours / other x
overheads budget machine hours / other allocation
allocation basis
basis

Note: Both budgets are based on the information from the standard cost card.

EXAMPLE:

The standard cost card for Product X is as follows:

Cost $

Direct materials - 4 kg of Material B @ $10 per kg 40

Direct labour - 2 hours @ $6 per hour 12

 Variable production overheads 2

Fixed production overheads 4

Total absorption cost 58

The business has budgeted to produce 1,800 units of Product X.

Calculate the following:

● Variable production overhead budget in $

● Fixed production overhead budget in $

Solution:

Variable production overhead budget in $ = $2 x 1,800 = $3,600

Fixed production overhead budget in $ = $4 x 1,800 = $7,200

 MA - Budgeting
Budgeted Statement of Profit or Loss

Budgeted statement of profit or loss = Estimate of earnings

Proforma of budgeted statement of profit or loss:

Narrative Description $ $

Sales revenue Budgeted sales volume x budgeted selling price x

Opening inventory # of units x standard cost x

Production costs Budgeted production volume x standard cost* x

Closing inventory # of units x standard cost (x)

Production cost of sales (x)

Gross profit x

Non-production overheads (x)

Net profit x

*Production costs budget can also be calculated as follows:

Materials Variable
Production Labour Fixed production overheads
= usage + + production +
costs budget budget (in absorption costing only)
budget overheads
 MA - Budgeting
Example Budget Preparation

PROFORMA OF BUDGETED STATEMENT OF PROFIT OR LOSS:

Narrative Description $ $

Sales revenue Budgeted sales volume x budgeted selling price x

Opening inventory # of units x standard cost x

Production costs Budgeted production volume x standard cost* x

Closing inventory # of units x standard cost (x)

Production cost of sales (x)

Gross profit x

Non-production overheads (x)

Net profit x

Production costs budget can also be calculated as follows:

Materials Variable Fixed production

Production Labour
= usage + + production + overheads (in absorption
costs budget budget
budget overheads costing only)

The master budget includes:

● Budgeted statement of profit or loss

● Budgeted statement of financial position
● Budgeted statement of cash flows

EXAMPLE:
The standard cost card for Product XYZ is as follows;

Standard cost per unit

$

Direct materials (2 kg @ $2.50) 5

Direct labour (15 minutes @ $8 per labour hour) 2

Variable production overheads (1 machine hour @ $0.50 per machine hour) 0.50

Fixed production overheads (1 machine hour at $1.50 per machine hour) 1.50

Total 9

In addition, the following information is relevant:

● The budgeted selling price is $25 per unit for sales of 10,000 units of Product XYZ
● Budgeted non-production overheads are $34,000
● Opening inventory of Product XYZ is 1,000 units
● Closing inventory of Product XYZ is 800 units

Prepare a budgeted statement of profit or loss for the business.

Solution:

$ $

Sales revenue - $25 x 10,000 250,000

Cost of sales

Opening inventory - 1,000 x $9 9,000

Production costs (10,000 + 800 - 1,000) - 9,800 x $9 88,200

Closing inventory 800 x $9 (7,200)

Cost of sales (90,000)

Gross profit 160,000

Non-production overheads 34,000

Net profit 126,000

 MA - Budgeting
Fixed Budgets

DEFINITION:

Fixed budget - the budget that is prepared for a fixed level of activity.

FIXED BUDGET PROFORMA:

Budgeted item Description Amount, $

Sales Expected number of units sold x Expected selling price

x
per unit

Direct materials Budgeted production x Quantity of material required per

(x)
unit of production x Standard material cost

Direct labour Budgeted production x Labour hours required per unit

(x)
of production x Standard labour cost per hour

Variable production Budgeted production x Labour hours worked per unit of

overheads production x Standard variable production overhead (x)
cost per hour*

Fixed production overheads Fixed amount not depending on the budgeted

(x)
production

Non-production overheads Fixed amount not depending on the budgeted

(x)
production

Profit X

* In case variable production overheads are linked to labour. Other calculation bases may be considered.

Note: In practise organisations are rarely able to estimate the number of units sold, so most companies prepare
budgets for more than one level of activity (flexible budgets).
 MA - Budgeting
Flexible Budgets

DEFINITION:

Flexible budget - a budget which shows revenues and expenditures of a company at different activity levels.

FLEXIBLE BUDGET PROFORMA:

Amount, $ Amount, $
Budgeted item Description
X level of activity Y level of activity
Expected number of units sold x Expected x y
Sales
selling price per unit
Budgeted production x Quantity of material (x) (y)
Direct materials required per unit of production x Standard
material cost
Budgeted production x Labour hours required (x) (y)
Direct labour per unit of production x Standard labour cost per
hour
Budgeted production x Labour hours worked per (x) (y)
Variable production
unit of production x Standard variable
overheads
production overheads cost per hour*
Fixed production Fixed amount not depending on the budgeted (x) (y)
overheads production
Non-production Fixed amount not depending on the budgeted (x) (y)
overheads production
Profit X Y

* In case variable production overheads are linked to labour. Other calculation bases may be considered.

Note: Spreadsheets and “what if analysis” are very useful tools in preparing flexible budgets quickly and
accurately. In order to make a valid comparison of budgeted and actual results in case where the actual level of
activity differs from that budgeted, it is necessary to flex the original budget (prepare flexed budget).

ILLUSTRATION 1:
A company prepared a fixed budget for the period. At the fixed activity level of 1,750 units, the budget is shown
below:

Type of revenue/cost Fixed budget - 1,750 units

$

Sales revenue Variable (1,750 x $90) 157,500

Materials Variable (1,750 x $40) 70,000

Labour Variable (1,750 x $12) 21,000

Variable overheads Variable (1,750 x $2) 3,500

Fixed overheads Fixed - $7,200 7,200

Non-production overheads Fixed - $15,000 15,000

Profit 40,800

The same company then prepared a flexible budget to show the different costs and revenue at three different
activity levels as follows:

1,750 units 1,925 units 2,100 units

$ $ $

Sales revenue 157,500 173,250 189,000

Materials 70,000 77,000 84,000

Labour 21,000 23,100 25,200

Variable overheads 3,500 3,850 4,200

Fixed overheads 7,200 7,200 7,200

Non-production overheads 15,000 15,000 15,000

Profit 40,800 47,100 53,400

 MA - Budgeting
Cash Budgets

Cash budget - budget which details the estimated cash inflows and outflows.

Key features:

- Concerned only with cash receipts and payments;

- Non-cash items (like depreciation of fixed assets) are ignored in cash budgets;
- Cash items which are not shown in the PL (like receipt for the sale of fixed asset - profit or loss on sale is
only shown in the PL) are incorporated into the cash budget;
- Timing of cash flows is crucial in preparing the cash budget.

Common tips for preparing cash budgets:

1) Revenue is usually expected to be spread evenly unless otherwise stated;

2) Suppliers could be paid at the end or at the start of the month of a purchase;
3) Labour is paid during the month of work;
4) Variable production overheads are paid during the month when they are incurred;
5) Fixed production overheads are paid during the month when they are incurred.
Cash budget proforma:
Quarter 1 Quarter 2 Quarter 3 Quarter 4
Sales receipts x x x x
Loan receipts x x x x
Sales of non-current assets x x x x
Total receipts x x x x
Materials x x x x
Labour x x x x
Variable overheads x x x x
Fixed overheads x x x x
Repayment of loans x x x x
Purchase of non-current assets x x x x
Total payments x x x x
Cash balance brought forward x x x x
Net cash inflow / (outflow) x x x x

Cash balance carried forward x x x x

Example 1:

A Company budgeted to sell 1,750 units of Product X and to produce 1,800 units of Product X in a given year.
The following information has been budgeted:

● A sales revenue budget of $157,500. Sales revenue is expected to be spread evenly throughout the year
and all sales are cash sales.
● A materials purchases budget of $73,000. Suppliers of materials are paid at the end the month in which
the materials were purchased.

● A labour budget of $21,600. Labour is paid in the month in which the work is carried out.

● A variable production overhead budget of $3,600. Variable production overheads are paid in the month
in which the overheads are incurred.

● A fixed production overhead budget of $7,200. Fixed production overheads are paid in the month in
which the overheads are incurred.

The company also took out an interest-free loan of $40,000 in Quarter 1 and repaid this loan in full in Quarter 4.

In addition, the company purchased a new non-current asset for $25,000 in Quarter 2 and sold the item of
equipment that it was replacing in Quarter 3 for $2,000.

The cash balance brought forward at the beginning of Year 2 is $15,000.

Using this information, prepare a 4-quarter cash budget for the company.

Solution:
 Quarter 1 Quarter 2 Quarter 3 Quarter 4
$ $ $ $

Sales receipts 39,375 39,375 39,375 39,375

Loan 40,000

Sale of non-current asset 2,000

Total receipts 79,375 39,375 41,375 39,375

Materials 18,250 18,250 18,250 18,250

Labour 5,400 5,400 5,400 5,400

Variable overheads 900 900 900 900

Fixed overheads 1,800 1,800 1,800 1,800

Repayment of loan 40,000

Purchase of non-current asset 25,000

Total payments 26,350 51,350 26,350 66,350

Cash balance brought forward 15,000 68,025 56,050 71,075

Net cash inflow/(outflow) 53,025 (11,975) 15,025 (26,975)

Cash balance carried forward 68,025 56,050 71,075 44,100

 MA - Budgeting
Cash Budgets and “What If” Analysis

There could be a wide range of potential situations relating to cash budgets.

Spreadsheets and various functions and tools in them can be used to modify drivers, revenue, expenses, and
payroll assumptions.

What if analysis is the process of changing the values in cells to see how those changes will affect the outcome
of formulas on the worksheet. Examples of changes in cash budgets where what if analysis can be helpful:

- Shift from purely cash sales to partial or full credit sales;

- Shift from purely cash purchases to partial or full credit purchases;
- Delay of loan repayment.

Cash budget proforma:

Quarter 1 Quarter 2 Quarter 3 Quarter 4
Sales receipts x x x x
Loan receipt x x x x
Sales of non-current asset x x x x
Total receipts x x x x
Materials x x x x
Labour x x x x
Variable overheads x x x x
Fixed overheads x x x x
Repayment of loan x x x x
Purchase of non-current asset x x x x
Total payments x x x x
Cash balance brought forward x x x x
Net cash inflow / (outflow) x x x x

Cash balance carried forward x x x x

Example 1:
A business has calculated the total receipts for four quarters to be as follows:

Quarter 1 Quarter 2 Quarter 3 Quarter 4

Sales receipts 10,000 11,000 12,000 13,000
Loan receipt 5,000 - - -
Sales of non-current asset 50,000 - - -
Total receipts 65,000 11,000 12,000 13,000

If the business decides to delay the sale of the non-current asset to Quarter 3 and the sale in Quarter 2 turns out
to be 50% lower, calculate the total receipts.

Solution:

Ideally, what-if analysis is performed with the help of a spreadsheet. You should attempt to do the same in the
spreadsheet.

Quarter 1 Quarter 2 Quarter 3 Quarter 4

Sales receipts 10,000 5,500 12,000 13,000
Loan receipt 5,000 - - -
Sales of non-current asset - - 50,000 -
Total receipts 15,000 5,500 62,000 13,000
 MA - Budgeting
Budgeted Statement of Financial Position

DEFINITION:

Budgeted statement of financial position details the assets and liabilities, and the share capital and reserves of
an organisation at the end of a budget period.

Budgeted statement of financial position proforma:

FS line item Description $ $

Non-current assets Net book value X

Current assets:

Inventory # units x unit cost (according to the selected inventory x

valuation technique)

Trade receivables Usually % of total sales and depending on credit terms x

offered to customers

Cash Closing balance according to the cash budget x

Total current assets X

Total assets X

Current liabilities:

Trade payables Usually % of total purchases and depending on credit

(x)
terms offered by suppliers

Other short-term liabilities Loans etc. (x)

Total current liabilities (X)

Total liabilities (X)

Net current assets Current assets - Current liabilities X

Net assets Total assets - Total liabilities X

Note: Other FS line items may be inserted into the budgeted statement of financial position depending on the
scenario. Equity and retained earnings may also be included.

ILLUSTRATION:

Budgeted statement of financial position proforma:

FS line item Description $ $

Non-current assets Net book value 100,000

Current assets:

Inventory 5,000 X $6 30,000

Trade receivables 45,000

Cash 15,000

Total current assets 80,000

Total assets 180,000

Current liabilities:

Trade payables (30,000)

Other short-term liabilities Loans etc. (40,000)

Total current liabilities (70,000)

Total liabilities (130,000)

Net current assets Current assets - Current liabilities 10,000

Net assets Total assets - Total liabilities 50,000

 MA - Budgeting
Budgetary Control

DEFINITIONS:

Flexed budget - a flexible budget revised at actual activity level. A flexed budget is prepared using the same
proforma as for a flexible budget, but only for actual level of activity.

Key points to remember: Variable expenses in a flexed budget are calculated similarly as for the flexible
budget. Fixed production and nonproduction overheads are not changed with the level of activity, so remain the
same.

VARIANCES:

Variances involve comparing the planned results with the actual results.

TYPES OF VARIANCES:

Favourable (F or Fav) Adverse (A or Adv)

- Actual results are better than budgeted results; - Actual results are worse than budgeted results;
- Have positive value; - Have negative value;

CONTROL STAGE OF PLANNING AND CONTROL CYCLE:

This stage begins with the measurement of actual results. The actual results are then compared with the flexed
budgets. The variances are calculated and the significant variances are investigated. The variances are also
broken down into sub variances.

If uncontrollable variances are identified before the period-end, necessary adjustments are made and the
budgets are revised accordingly.

BUDGETARY CONTROL REPORT TEMPLATE:

Budgeted item Flexed budget Actual results Variances

Sales X Y Z-A/F

Cost of sales:

Direct materials (x) (y) z - a /f

Direct labour (x) (y) z - a /f

Variable production overheads (x) (y) z - a /f

Fixed production overheads (x) (y) z - a /f

Cost of sales (X) (Y) Z-A/F

Gross profit X Y Z-A/F

Non-production overheads (X) (Y) z - a /f

Net profit X Y Z-A/F

BUDGETARY CONTROL REPORT - ILLUSTRATION:

Budgeted item Flexed budget Actual results Variances

$ $ $

Sales 175,500 157,950 17,550 (A)

Cost of sales:

Direct materials (78,000) (70,200) 7,800 (F)

Direct labour (23,400) (27,300) 3,900 (A)

Variable production overheads (3,900) (4,095) 195 (A)

Fixed production overheads (7,200) (7,480) 280 (A)

Cost of sales (112,500) (109,075) 3,425 (F)

Gross profit 63,000 48,875 14,125 (A)

Non-production overheads (15,000) (14,800) 200 (F)

Net profit 48,000 34,075 13,975 (A)

 MA - Budgeting
Compounding

Interest - amount earned when money is invested, or amount that it costs to borrow money. There are two types
of interest:

- Simple;
- Compound.

Compounding - reinvesting interest that is earned from a sum of money each year, so that the interest earned
earns further interest.

Compounding formula:

Types of interest:

1) Nominal interest - interest rate stated without compounding.

2) Effective interest - nominal interest rate expressed in terms of an annual rate (compounded or annual
percentage rate):

1 + R = (1 + rn)

Remember: Discounting is opposite of compounding.

Example 1:
John deposits $2,000 in the bank for five years. The bank pays simple interest at a rate of 5% per year.
Calculate the total interest earned by John over the period of five years.

Solution:

Interest each year = $2,000 x 5% = $100

Total interest over five years = $100 x 5 = $500

Example 2:

John deposits $2,000 in the bank for five years. The bank pays compound interest at a rate of 5% per year.
Calculate the total interest earned by John over the period of five years.

Solution:

FV = PV x (1+r)n

FV = 2,000 x (1+ 0.05)5

FV = 2,552.6

Interest = FV - PV

Interest = $2,552.6 - $2,000

Interest = $552.6
 MA - Budgeting
Discounting

DEFINITIONS:

Compounding - reinvesting interest that is earned from a sum of money each year, so that the interest earned
earns further interest.

Discounting is the process of determining the present value of a payment, or a stream of payments, that is to
be received in the future. Discounting is the opposite of compounding.

FORMULAE:

PV = FV / (1+r)n

Note: 1/(1+r)n = Discount factor. It can be found in discount factor tables as well.

EXAMPLE:

Steven is given a choice of receiving $11,000 now or $15,000 in five years’ time. Interest rates are 10%.
Determine which offer is more beneficial for Steven.

Solution:

We need to calculate the present value of $15,000 received in five years’ time. This value can be compared
with the current offer of $11,000 to determine which one is more beneficial.

PV = FV / (1+r)n

PV = $15,000 / (1+0.1)5

PV = $9,312.8

The present value of $15,000 is lower than $11,000. Therefore, it is beneficial for Steven to accept $11,000
now.
 MA - Budgeting
Annuities

DEFINITION AND FORMULA:

Annuity is a constant cash flow for a specified number of years. The present value (PV) of an annuity is
calculated using annuity factors (table).

PV of annuity = Annuity x Annuity factor

Important assumption: First cash flow is assumed to occur in one year’s time.

SCENARIOS:

First payment is made in one year’s time Calculate PV of annuity using the above formula.

First payment is made immediately (at Calculate PV of annuity by increasing the ordinary
time 0) annuity factor by 1 (AF + 1).

1) Calculate PV of annuity as if payments happen

during all years;
First payment is made in ‘n’ year’s time
2) Discount PV of annuity back using same % for n
years.

EXAMPLES:

Example 1:

Robyn receives $1,500 a year for ten years. Interest rates are 5%. Calculate the PV of the annuity.

Solution:

PV of annuity = $1,500 x 7.722

PV of annuity = $11,583

Example 2:

Robyn receives $1,500 a year for ten years when interest rates are 5% and the first payment is made in three
years’ time. Calculate the PV of the annuity.

Solution:

Value of annuity in three years’ time = $1,500 x 7.722

Value of annuity in three years’ time = $11,583

PV of annuity now = $11,583 x 0.907

PV of annuity now = $10,506

 MA - Budgeting
Perpetuities

DEFINITION AND FORMULA:

A perpetuity is a constant flow of cash which lasts forever. In order to calculate the present value of a
perpetuity, we can use the following formula:

PV (perpetuity) = Constant cash flow / Interest rate

The present value of a perpetuity can also be calculated using the formula:

PV (perpetuity) = Perpetuity x Annuity factor

Annuity factor = 1 / Interest rate

SCENARIOS:

In order to calculate the present value of a perpetuity when the first payment is made now (T 0), rather than in
one year’s time, we use the following formula:

PV (from time zero) = Perpetuity x Annuity factor + Payment at time zero (T0)
or
PV (from time zero) = Perpetuity x (Annuity factor + 1)

When the first payment is made in two years’ time (T2), the value of a perpetuity is calculated as follows:

PV (perpetuity) = (Constant cash flow / Interest rate) x Discount factor (n=1)

EXAMPLES:

Example 1:

Robyn receives $1,500 a year in perpetuity when interest rates are 5%. Calculate the present value of the
perpetuity.

Solution:
PV of perpetuity = $1,500 / 0.05

PV of perpetuity = $30,000

Example 2:

Robyn receives $1,500 a year in perpetuity when interest rates are 5% and the first payment is to be made now.
Calculate the present value of the perpetuity.

Solution:

PV of perpetuity = $1,500 / 0.05

PV of perpetuity = $30,000

Value of first payment = $1,500

Total PV including first payment = $30,000 + $1,500

Total PV including first payment = $31,500

Example 3:

Robyn receives $1,500 a year in perpetuity when interest rates are 5% and that the first payment is to be made
in two years’ time. Calculate the present value of the perpetuity.

Solution:

PV of perpetuity in two years’ time = $1,500 / 0.05

PV of perpetuity in two years’ time = $30,000

PV of perpetuity now = $30,000 x 0.952

PV of perpetuity now = $28,560

 MA - Budgeting
Capital Investment Appraisal

DEFINITION:

Capital investment appraisal involves looking at the amount of money that it will cost to invest in a project and
the amount of money that is likely to be generated during the lifetime of the project.

CASH FLOWS TO CONSIDER:

Only relevant cash flows should be considered - actual cash movements in or out of an organisation:

1) Future costs / revenues;

2) Incremental costs / revenues.

All other costs are irrelevant.

Examples of relevant cash flows:

● Initial cost of investing in a project
● Annual direct running costs
● Estimated annual income
● Potential cost savings
● Residual values

Incremental costs or revenues represent the increase in costs or revenues that arise as a direct result of the
decision to invest in a future project.

Past / sunk costs are not directly attributable to the decision.

CAPITAL INVESTMENT APPRAISAL STEPS:

● Identifying of relevant cash flows

● Calculating of net cash inflows or outflows
● Discounting to present value annual income
● Evaluating on the basis of NPV, IRR or any other DCF technique
 MA - Budgeting
Net Present Value

STEPS TO CALCULATE NPV:

- Identify relevant cash flows

- Include relevant cash flows in the NPV table
- Calculate net cash flows
- Identify PV of the cash flows based on discount factor
- Calculate NPV

NPV PROFORMA:

Year (Initial outflow) / Cash Cash Cash Net total cash inflow / Discount factor Present
Residual value flow 1 flow ... flow n (outflow) at given % value

0 (x)

1 x / (x) x / (x) x / (x) X / (X) r X / (X)

... x / (x) x / (x) x / (x) X / (X) r X / (X)

n x x / (x) x / (x) x / (x) X / (X) r X / (X)

Total NPV X / (X)

Key selection criteria: Invest in project with highest NPV.

Note:
Required rate of return = Target rate of return = Cost of capital

Example 1:
An organisation is considering investing in a project which will last for four years and which will require the
purchase of a new machine. Details of the new machine are as follows:

● The machine will cost $450,000 and will be depreciated at an annual rate of $95,000 in the four years
that the organisation will use it.
● Sales revenue of $150,000 in the first three years is forecast to be generated as a result of purchasing
the machine. In the fourth year, the sales revenue is expected to increase by 20%.
● The annual running costs of the new machine are forecast to be $30,000.
● The machine is expected to be sold at the end of four years for $70,000.

The organisation’s required rate of return (or target rate of return) for potential new projects is 8%. Calculate the
NPV.

Solution:

Year Investment and Sales Machine running Net cash Discount factor PV
residual value revenue costs inflow/outflow at 12%

$ $ $ $ $

0 (450,000) (450,000) 1.000 (450,000)

1-3 150,000 (30,000) 120,000 2.402 288,240

4 70,000 180,000 (30,000) 220,000 0.636 139,920

Net present value (21,840)

 MA - Budgeting
Internal Rate of Return

DEFINITION AND FORMULA:

Internal rate of return (IRR) - discount rate at which a net present value of a potential new project is zero.

a * (B - A)
IRR = A +
a-b

where:
A - lower discount rate
B - higher discount rate
a - NPV at the lower discount rate
b - NPV at the higher discount rate

ILLUSTRATING IRR:
CHOICE RULES:

If IRR is higher than target rate of return Accept project

If two or more projects has IRR higher than
Select the project with the highest IRR
target rate of return
 MA - Budgeting
Payback

DISCOUNTED PAYBACK CALCULATION IN STEPS:

Payback is a capital appraisal technique which aims to establish a point in time at which investment in a project
has been paid back. Calculation of a discounted payback includes the following steps:

1) Calculate discounted cash flows of a project;

2) Calculate cumulative cash flow at the end of each period;
3) Determine in which period the project becomes NPV-positive, from being NPV-negative;
4) Determine the exact point of time in this period by time-apportionment (assuming that cash flows were
spreading evenly throughout the year).

Discounted payback proforma:

Year Net cash inflow / outflow PV of net cash inflow / outflow Cumulative cash flow

1 X1 Y1 Y1

2 - ... X2 - ... Y2-... Y1 + Y2-...

n Xn Yn Y1 + Y2-... + Yn

Total Y

UNDISCOUNTED PAYBACK CALCULATION IN STEPS:

1) Calculate the cumulative undiscounted cash flow at the end of each period;
2) Determine in which period the project becomes positive, from being negative;
3) Determine the exact point of time in this period by time-apportionment (assuming that cash flows were
spreading evenly throughout the year).

Undiscounted payback proforma:

 Year Net cash inflow / outflow Cumulative cash flow

1 X1 X1

2 - ... X2 - ... X1 + X2-...

n Xn X1 + X2-... + Xn

Total X

Note: Select the project with the shortest payback period.

Example 1:

The following table indicates the cash flows and the present value of the cash flows for a specific project:

Year Net cash inflow/outflow at 8% Present value

$ $

0 (450,000) (450,000)

1-3 120,000 309,240

4 220,000 161,700

Net present value 20,940

Calculate the discounted payback period.

Solution:

Year Net cash inflow/outflow at 12% Present value Cumulative cash flow

$ $ $

0 (450,000) (450,000) (450,000)

1-3 120,000 309,240 (140,760)

4 220,000 161,700 (20,940)

140,760/161,700 x 12 months = 10.44 = 11 months

Discounted payback period = 3 years and 11 months

 MA - Management Accounting
Budgetary Control and Reporting

Budgets are powerful evaluation tools. Actual results are measured against budgeted results. Actual sales or
activities rarely match the budget exactly. Budgets are flexed to match the actual output and to find the
variances between the actual and budgeted activities.

The reasons for variances must be found so that adverse trends are corrected and favourable ones are
exploited. Let’s look at an example:

Monsters Inc. has prepared a budget for the year ended December 20X6 (Fig. 1). In January, the financial team
put together the actual information.

Budgeted ('000) Actual ('000)

Units 40,000 60,000

Revenue $260,000 $300,000

Material $80,000 $96,000

Variable
Costs
Labour $65,000 $83,200

Contribution Margin $115,000 $120,800

Factory Overhead $30,000 $25,880

Fixed Costs
Office Expenses $15,000 $25,000

Operating Income $70,000 $69,920

Fig. 1

Management expected a higher income as more units were sold than they budgeted. However, income was well
below budget. A flexed budget will let you see why the income is lower than expected. The variances between
the flexed budget and the actual results are shown below (Fig. 2).
 Budgeted ('000) Per Unit Flexed Budget ('000)

Units 40,000 1 60,000

Revenue $260,000 $6.50 $390,000

Material $80,000 $2 $120,000

Variable
Costs
Labour $65,000 $1.63 $97,500

Contribution Margin $115,000 $3 $172,500

Factory $30,000 $30,000 $30,000

Overhead
Fixed
Costs
Office $15,000 $15,000 $15,000
Expenses

Operating Income $70,000 - $127,500

Fig. 2

The flexed budget applies the budgeted amounts based on the actual output levels.

The budgeted variable costs per unit are calculated. This is done by dividing the budgeted revenues and
variable costs by the budgeted units. Then multiply this figure by the actual output to get the flexed budget.

The fixed costs in the flexed budget don’t change. A fixed cost variance is the difference between budgeted cost
and the actual cost.

Actual ('000) Flexed Budget Variance ('000) Favourable /

('000) Unfavourable

Units 60,000 60,000 - -

Revenue $300,000 $390,000 ($90,000) Unfavourable

Material $96,000 $120,000 ($24,000) Favourable

Variable
Costs
Labour $83,200 $97,500 ($14,300) Favourable

Contribution Margin $120,800 $172,500 ($51,700) Unfavourable

Fixed Factory Overhead $25,880 $30,000 ($4,120) Favourable

 Costs Office Expenses $25,000 $15,000 $10,000 Unfavourable

Operating Income $69,920 $61,500 $8,420 Unfavourable

Fig. 3

In Fig. 3 we can see the variances between the flexed budget and the actual results. These variances are found
by subtracting the budgeted amount from the actual results.

A variance can be:

● Favourable: A positive variance, for example, costs are less than expected.

● Unfavourable/Adverse: A negative variance reduces expected profitability. For example, costs being
more than budgeted.

● No variance: This is when the budget and the actual results match. This is good because it means the
company is meeting its targets.

Overall the income was $8.4 million less than expected. That is 14% of the budgeted income, which is
significant.

VARIANCE ANALYSIS

Figure 4 is an analysis for the variances found in Monsters Inc. It provides possible reasons and corrective
action that can be taken. An accountant would be expected to make these recommendations.

Variance Reason Action

All the variances in Variances can occur because of incorrect Setting a budget should be a
Monsters Inc. information used in the original budget. companywide exercise. The more people
involved and checking the figures, the less
likely a mistake will go through.

Those responsible for an area, such as

department managers, should budget the
costs and be held responsible for the
information they provide.

An adverse revenue This is due to reduced sales prices. Market research is needed to anticipate
variance Perhaps because: competitor’s actions and consumer trends
which can then be budgeted.
● Competitors are offering lower
prices or consumers being The marketing team must communicate
unwilling or unable to pay the promotional activities and their impacts on
budgeted price. revenues and costs to the budgeting team.

● Promotional offers such as buy

one get one free.
 Favourable Reduced material costs could be due to: This is a favourable variance.
variance in
materials cost ● Sourcing cheaper materials The reasons for it should be found by
discussing with the production managers.
● Negotiating lower prices from
existing suppliers Management should try to replicate these
efficiencies found into other departments.
● Buying larger quantities to get
discounts
The long-term impact of these actions
● Using more efficient production must be assessed.
methods.

Favourable Lower labour costs could be due to: This is a favourable variance.
variance in labour
cost ● Reducing wages, i.e., a wage rate The reasons for it should be found by
variance discussing with the HR managers.
● Finding more efficient production Management should try to replicate these
methods, i.e., a labour efficiency efficiencies found into other departments.
variance
The long-term impact of these actions
● Mechanisation
must be assessed.

Fixed costs have an The increase in the units sold could cause The reasons for this variance must be
unfavourable the fixed costs to increase in a new range found by looking at the individual
variance of production. breakdown of the expenses.

Fig. 4

RESPONSIBILITY ACCOUNTING

Responsibility accounting's objective is to accumulate costs and revenues for each individual responsibility
centre so the variances from the budgets can be attributed to an individual, like a department head.

Responsibility accounting is based on the controllability principle. The controllability principle states that
people should only be held responsible for what they control. So, controllable and uncontrollable costs must be
identified. In business, this is not simple because many costs have controllable and uncontrollable elements.

IDENTIFYING CONTROLLABLE AND UNCONTROLLABLE COSTS

The committee of cost concepts and standards in the United States published a report in 1956 with guidelines to
identify uncontrollable and controllable costs. We can still use these guidelines today.

1. If a manager can control the quantity and price paid for a product or service, then the manager is
responsible for all the expenditure incurred for that product or service.

2. If a manager can control the quantity of the service but not the price paid, then they should only be
responsible for the amount of difference between the actual and budgeted expenditure that is due to the
usage.

3. If the manager cannot control the quantity or the price paid, then this expense is uncontrollable and
should not be assigned to a manager.
However, in the real world a general rule is to hold managers responsible for areas you want them to pay
attention to. If an employee believes a cost is uncontrollable they will not be motivated to take steps to reduce it.
Sometimes an expense is uncontrollable but actions can be taken to reduce its impact. For example, a manager
cannot control what competitors do, but they can take steps, like reducing sales price, to reverse the effects of
this uncontrollable circumstance.

CONTROL REPORTS
Regular control reports need to be given to the people responsible for the cost to implement responsibility
accounting.

● These reports will show the budgeted cost for their area, the actual cost and the variances.

● These reports, often monthly, enable managers to act on variances before the financial year end.

The recommendations and reports should also include non-financial factors, for example, any changes in
product quality.

The F2 Syllabus requires students to be able to prepare control reports and give recommendations to
management.

Below is a control report for the Managing director (Fig. 5). It is an overall summary of the variances in the
company. The higher the management level, the less detail given. Costs are not broken down like they are in the
department manager's report (Fig. 6) or the cost centres managers’ report (Fig. 7).

The Managing Director's monthly control report for January 20X6

Actual ('000) Flexed Variance ('000) Favourable /

Budget ('000) Unfavourable
For Jan Year to date

Units 5,000 5,000 - - -

Revenue $25,000 $32,500 ($7,500) ($7,500) Unfavourable

Material $8,000 $10,000 ($2,000) ($2,000) Favourable

Variable
Costs
Labour $6,933 $8,125 ($1,192) ($1,192) Favourable

Contribution Margin $10,067 $14,375 ($4,308) ($4,308)

Factory $2,157 $2,500 ($343) ($343) Favourable

Overhead
Fixed
Costs
Office $2,083 $1,250 $833 $833 Unfavourable
Expenses

Operating income $5,827 $10,625 ($4,798) ($4,798) Unfavourable

 Fig. 5

(continued on next page…)

The Office manager's monthly control report for January 20X6

Actual ('000) Flexed Variance ('000) Favourable /

Budget ('000) Unfavourable
For Jan Year to date

Supervisors $1,000 $550 $450 $450 Unfavourable

Complaints Staff $733 $500 $233 $233 Unfavourable

Stationary $200 $100 $100 $100 Unfavourable

Phone and internet $150 $100 $50 $50 Unfavourable

Office expenses $2,083 $1,250 $833 $833 Unfavourable

Fig. 6

The Office manager's' report breaks down the office expenses. Office expenses was one figure on the Managing
Director's report. This is the office manager's area of responsibility and he or she should take actions to reduce
these unfavourable variances.

The Complaints staff manager's monthly control report for January 20X6

Actual ('000) Flexed Variance ('000) Favourable /

Budget ('000) Unfavourable
For Jan Year to date

Staff Count 20 19 - - -

Complaints Staff Salary $400 $450 ($50) ($50) Favourable

 Complaints Staff Bonus $8 $10 ($2) ($2) Favourable

Complaints Staff $50 $10 $40 $40 Unfavourable

Overtime Week 1

Complaints Staff $75 $10 $65 $65 Unfavourable

Overtime Week 2

Complaints Staff $100 $10 $90 $90 Unfavourable

Overtime Week 3

Complaints Staff $100 $10 $90 $90 Unfavourable

Overtime Week 4

Complaints Staff $733 $500 $233 $233

Fig. 7

Figure 7 shows how detailed the information is for this cost centre. Non-financial information like staff numbers
are provided.
 MA – Budgeting
Budgeting and Behaviour

IMPORTANCE OF MOTIVATION ON PERFORMANCE:

Motivation:
Motivation is the desire to perform. We are all motivated by different desires and goals in life. One key
challenge for management is to create a system of performance management that manages employee
motivation and channels their effort towards helping to achieve organisational goals. When the employees’ goals
are aligned to the organisation’s, this is known as ‘goal congruence’.

Without motivation, employees would be unproductive and the organisation would be unable to meet its goals.

Budgets and motivation:

Budgets are a part of the overall performance management framework in the organisation, and as such are used
to help influence motivation. Let’s consider how budgeting impacts motivation and behaviour.

Hopefully, having a target to aim for that the employee feels is challenging but achievable, and that the
employee feels they want to achieve (for example, if they earn a bonus by reaching the target, or some other
form of reward like a promotion) will mean they are motivated and will work towards that target.

THE IMPACT OF PARTICIPATION IN THE BUDGET SETTING PROCESS:

However, sometimes budgets can actually have a negative impact on motivation. This could be due to several
reasons.

Top-down budgeting:
If those who set the budget are not responsible for reaching the target, the manager working towards the target
may feel they do not ‘own’ the target and may even reject it, especially if it is unrealistic. Imposing a target on
employees is known as ‘top-down budgeting’. Typically with top-down budgeting, senior management will
dictate the targets and pass them down to middle management.

Disadvantages of top-down budgeting:

Imposing budgets in this way can be problematic in many ways:

● The budget may end up being unrealistic, particularly if top management is a little ‘out of touch’ with the
detail of day to day operations. As a result, the budget may be too easy or too difficult to achieve. Either
could cause employees to underperform (too easy: relax! Too difficult: give up!). In other words, the budget
won’t motivate staff.

● It takes senior management time which might be better spent on other things. It also limits the total mental
effort going into the budgets to the senior management team, the skills of middle management are under-
utilised.

● Middle management may not feel emotionally that the targets are ‘theirs’. This lack of ownership limits
motivation. A target you come up with yourself is more your responsibility. If you miss that target, you can’t
blame someone else for the target being unrealistic!

Advantages of top-down budgeting:

A top-down approach does have some advantages:

● It is relatively quick, it does not take long for a small group of people to come up with the target and merely
communicate it to others.

● It may actually end up being more realistic, senior management is often very experienced, are in touch with
the needs of the wider stakeholder community (such as shareholders and lenders), and will not build in
budgetary slack to the budgets.

● Budgetary slack is a problem experienced when people are asked to come up with their own targets. For
example, if a manager asks an employee; ’how long will this job take?’, the employee may think to
themselves ‘probably 2 days but I’ll say 3 to give myself a bit of a buffer in case anything goes wrong’. The
extra day they have built in is known as ‘budgetary slack’, and is often a significant issue when employees
are asked to prepare their own budgets.

A top down approach might be more appropriate in certain circumstances, for example:

● If a business is new, or very small, then the owner/manager might be best placed to set targets as they
probably know more than most about the plans of the business.
● In ‘tough times’, for example, if there are serious cash flow issues, sometimes targets have to be imposed to
ensure the survival of the business.
● Middle managers may not possess the necessary skills to put budgets together, so senior management may
have little choice.

Bottom-up budgeting:
The opposite of a top-down approach is known as bottom-up. With bottom up budgeting, middle management
is asked to calculate their own budgets. They are then aggregated to give the overall budget for the whole
organisation. This is also known as ‘participative budgeting’.

Advantages of bottom-up budgeting:

Participation in this way may well improve motivation for several reasons:

● Targets were derived from those responsible for achieving them - there is likely to be a stronger sense of
ownership of them.
● They may be more realistic as middle managers are often closer to the detail and know more what to expect.
● It improves the skills of middle management if they get exposure to building budgets.
● It frees up senior management time to concentrate on other things.

Disadvantages of bottom-up budgeting:

However, bottom up budgeting takes time and money, may build in the budgetary slack and may not add up to
the targets that, for example, shareholders want!

Negotiated budgeting:
In many cases, a combination of top-down and bottom-up is used. often called ‘negotiated budgeting’. Middle
management may come up with initial targets that senior management then ‘tighten’ through a series of
negotiations. This process seeks to find a happy middle ground of motivated managers with realistic, challenging
but achievable targets.

ANTHONY HOPWOOD’S MANAGEMENT STYLES:

Anthony Hopwood considered the style management adopt when using budgets to manage a business and the
impact this has on behaviour. He identified 3 styles:

1. Budget constrained:
A budget constrained manager will see each line of a budget as an absolute limit and will strive to stick
within each aspect of the budget. This zealous approach may sometimes lead to frustrating decisions.

For example, suppose the training budget has been spent for the year, but there is an unexpected change in
tax legislation that everyone needs training on so they can do their jobs. A budget constrained manager may
say ‘you can’t have the training, we don't have the budget’. This can lead to frustration amongst staff, poor
staff relations and poor motivation.
 Hopwood also suggested that the budget constrained manager is also more likely to ‘massage’ reports,
manipulate information to ensure they ‘look good’ in relation to the budget.

At times, however, it might be necessary to adopt this style, for example with dangerously low cash flows,
and so overspending may threaten the survival of the organisation.

2. Profit conscious:
A profit conscious style, in a sense, is a little more relaxed and balanced. The profit conscious manager
makes decisions that are good for profits overall.

In the previous example of a change in tax legislation, they would probably authorise the training on the
basis that it is good for profits overall.

Staff relations and motivation tend to be better with this style, and the manager themselves is less likely to
manipulate reports comparing budget to actual performance.

3. Non-accounting style:
A non-accounting style focusses on ‘doing a good job’. The ethos here is that ‘If I do the best job I can,
whatever the profits are, they are the best they could have been’. This type of manager doesn’t particularly
use budgets to guide decisions.

Staff relations may generally be good, but motivation may not be as focused on targeted performance as
perhaps it should be.

UNINTENDED CONSEQUENCES OF BUDGETING:

Budgets can have unintended consequences, like:

● Pressure groups may form. A pressure group is a group of people who collectively reject the budget,
almost like a rebellion, ‘everyone around here thinks the budgets are poor so I’ll ignore them too!’
● They can create a blame culture when budgets are used to identify who is responsible for poor
performance. This in itself can create a negative and de-motivational working environment.
● In a changing and unpredictable environment, targets will probably end up being unrealistically high or
unrealistically low. This is because the future is difficult to predict. High or low targets both demotivate as
we’ve already said!

CONTROLLABILITY AND MOTIVATION:

The issue of controllability also affects motivation. Care should be taken to ensure budgets given to a manager
relate to items they have control over. If they contain items that the manager cannot control, this could seriously
demotivate the manager.

For example, if an uncontrollable cost increases substantially and the manager is held to account for this, as
they had no control over it in the first place, they cannot take any corrective action, and they will feel frustrated
that they are being made responsible!

IMPACT OF INCENTIVE SCHEMES ON BEHAVIOUR:

Incentive schemes should be carefully designed to help motivate individuals appropriately. An incentive
scheme should seek to reward individuals for goal congruent performance. Ideally, it should also be flexible to
individual needs and desires, for example, a financial bonus may incentivise some, but other benefits in kind
may motivate others.

The targets to trigger incentives needs to be carefully considered, Colin Drucker (amongst others) once said;
‘what gets measured gets done’, so setting the wrong targets in incentive schemes can encourage the wrong
types of behaviour. For example, paying a large bonus for annual profit may encourage dysfunctional
behaviour. A manager may cut back on training and research and development to secure a bonus this year, but
is actually damaging the long run performance of the business.

Care needs to be taken to ensure incentive scheme targets reflect the short and long term needs of the
business.

SUMMARY:

● Ultimately the main reason to prepare budgets is to motivate employees to behave in a goal congruent
manner.
● Care, therefore, needs to be taken when designing the budget preparation process, and the subsequent use
of budgets, to ensure they are realistic and that the manager responsible for them feels like they ‘own’ the
target.
● The targets used in incentive schemes should be consistent with the budget targets of the business to
secure the individual’s motivation to behave appropriately.