Topic 25: Budgeting and Variance analysis

Question 1

What is a Budget?

Answer 1

A budget is a quantitative plan of action for a future period.

It is a document which translates
a company’s objectives into financial terms.

It identifies the resources and expenditures that will be required over a limited time period, usually a year with sub-period of a month.

There is usually a budget for each key area.

It is used as a basis to prepare projected financial statements

Question 2

What are the steps involved in the budgeting process?

Answer 2

The budgeting process involves the following steps:

 Establish who will take responsibility.

 Communicate budget guidelines to relevant managers.

 Identify the key or limiting factor.

 Prepare the budget for the area of the limiting factor.

 Review and coordinate budgets.

 Prepare the master budgets.

 Communicate the budgets to all interested parties.

 Monitor performance relative to the budget.

Question 3

What is a Master budget?

Answer 3

A master budget is a comprehensive set of budgets that covers all phases of a business’ planned activities for a specified period of time.

It comprises operating budgets and financial budgets.

Question 4

What are Operating Budgets?

Answer 4

Operating budgets cover the business’ planned operating activities for a particular period of time, including expected sales, production, raw materials purchases, direct labour, production overhead and expenses.

When these budgets are combined together, they form a budgeted
income statement which shows net profit.

Question 5

What are Financial budgets?

Answer 5

Financial budgets focus on financial resources needed to support operations.

The cash budget provides information about budgeted cash payments and receipts.

The capital expenditure budget relates to the purchase of long term assets eg.property, equipment.

The cash budget and the capital expenditure budget impacts the balance sheet which shows the
assets, liabilities and equity at the end of the budget period.

Question 6

How is a Cash budget prepared?

Answer 6

The preparation is basically as follows:
 Start with the opening cash balance
of the month.
 Add all receipts for the month.
 Deduct all payments for the month.
 End with the closing cash balance of the month.

Question 7

What is the purpose of a budgeted income statement?

Answer 7

The purpose of the budgeted income statement is to summarise and integrate all the operating budgets so as to measure the end result or the company’s profit.

Question 8

Note:

In a retailing firm, the production budget is replaced by a purchase budget which shows the quantity of goods that should be bought for resale.

Question 9

What is a Master budget?

Answer 9

The master budget is a static budget which is a budget based on a fixed volume of output.

Question 10

What is a Flexible budget?

Answer 10

Flexible budgets are prepared to allow meaningful comparisons between the master budget
and actual performance.

Flexible budgets are revisions of the original budget to take into
consideration varying levels of output.

Flexible budgets allow more valid comparisons between the budget and the actual figures.

Question 11

What is Variance analysis?

Answer 11

Variance analysis is the process of comparing actual and budgeted results.

Variances indicates if managers need to take corrective action to get the business back on course.

Variances can be favourable where actual costs is less than budgeted or where income is more than budgeted.

Unfavourable or adverse variances occur when actual costs is greater
than budgeted or actual income less than budgeted.

Question 12

What are the reasons for adverse sales volume variance?

Answer 12

Possible reasons for adverse sales volume variances:
 Poor performance by sales staff
 Deterioration in market conditions between the time the budget was set and the actual event.
 Lack of goods or services to sell as a result of production problems.

Question 13

What are Volume variances?

Answer 13

Volume variances are calculated by comparing the master budget to the flexible budget.

The master budget is based on the sales forecast or estimated sales volume, while the flexible budget is based on the actual sales volume.

Question 14

What are Spending variances?

Answer 14

Spending variances are calculated by comparing actual costs to the flexible budget.

As actual costs and flexible budget are both based on actual sales volume, it provides a similar basis of comparison of spending.

Question 15

What are the possible reasons for favourable sales price variances?

Answer 15

Possible reasons for favourable sales price variances:
 Better performance by sales staff.
 Improvement in market condition between the time of the budget and the actual event.

Question 16

Note:

Go to notes pg 14 to read up on Sales volume variance and Sales price variance.

Question 17

What are the possible reasons for adverse direct material usage variance?

Answer 17

Possible reasons for adverse direct material usage variance:
 Poor performance by production staff, leading to high rates of scrap.
 Substandard materials, leading to high rates of scrap.
 Faulty machinery, causing high rates of scrap.

Question 18

What are the possible reasons for favourable direct materials price variance?

Answer 18

Possible reasons for favourable direct materials price variance
 Better performance by the buying department staff.
 Using lower quality material than planned.
 Change in market conditions between the time when the budget was set and the actual event.

Question 19

Note:

Go to pg15 to read up on Direct material usage variance and Direct material price variance

Question 20

What are the possible reasons for favourable labour efficiency variance?

Answer 20

Possible reasons for favourable labour efficiency variance:
 Better supervision
 A higher skill grade of worker taking shorter to do the work than envisaged for a lower skilled worker.
 Higher grade materials, leading to low levels of scrap and wasted labour time.
 Machinery running more smoothly than expected, leading to less labour time being wasted.

Question 21

What are the possible reasons for adverse labour rate variance?

Answer 21

Possible reasons for adverse labour rate variance:
a Poor performance by human resources department.
b Using a higher grade of worker than planned.
c Change in labour market conditions between the time budget was set and
the actual event.

Question 22

What are the possible reasons for adverse fixed overhead spending variance?

Answer 22

Possible reasons for adverse fixed overhead spending variance:
 Poor supervision of overheads.
 General increase in costs of overheads not taken into account in the budget.

Question 23

Note:

Go to pg 16 to read up on Fixed overhead spending variance

Question 24

Why should Variances be investigated?

Answer 24

 Significant adverse variances should be investigated as a continuation of the underlying
problem could be costly.

 Significant favourable variances should probably be investigated.

They may not be of immediate concern as compared to adverse variances, they still indicate that things are not going according to plan.

It could indicate that the budget is unrealistically low.

 Insignificant variances should be kept under review as cumulatively such insignificant variances may indicate areas of concern.

Question 25

Behavioural effects of budgets

Answer 25

Budgets can have unintended effects on the employee behaviour which depends on how goals and budgets are set and evaluated.  For the targets to be motivating, the budgets should be tight but attainable. Targets which are too easy does not require much work while targets which are too demanding can lead to frustration and in employees giving up altogether. Both can demotivate employees.  A participative approach is more likely to motivate people to work towards the business’ goals than a top-down approach. A participative approach allows employees throughout the organization to have an input in the budget setting process. However, a bottom up approach may result in budgetary slack.  Conflicts may arise in the budget setting process as different groups in the business may have different agendas. Such conflicts if managed well may result in better decisions being made. Negotiations can take place and options explored. This promotes better understanding by all parties of the issues involved which may result in demanding, yet achievable targets.  Subordinates of managers who focuses rigidly on the ability of their subordinates to meet the budget tend to manipulate the budget figures or to take other undesirable action to ensure the budgets were met.

Question 26

SUMMARY

Answer 26

 Budgeting is one of the most important tools that management has at its disposal in planning for the attainment of the company’s goals. It is crucial to both the efficient planning of operations as well as to the control of these operations.  The master budget system introduced here shows how the various individual budgets fit together and ultimately lead to the preparation of budgeted or pro forma financial statements for the period.  For ease of illustration, the process was illustrated for a quarterly budgeting system, but in practice monthly budgets are more common.  The preparation of all other budgets depends to some extent on an accurate forecast of sales which is the limiting factor for most businesses.  Once the operating budgets are prepared, the cash budget follows, showing the planned cash receipts and cash payments and the estimated future cash position.  To exercise control, budgets can be flexed to match actual volume of output.  Variances can be favourable or adverse according to whether they result in an increase or decrease from budgeted profit.  Variances can be classified as volume or spending variances.  Significant and /or persistent variances should be investigated to establish their cause.  Good budgetary control requires establishing systems and routines to ensure a clear distinction between individual managers’ areas of responsibility; prompt, frequent and relevant variance reporting; and senior management commitment.  There are behavioural aspects of control relating to management style, participation in budget setting and failure to meet budget targets that should be taken into account by senior managers.