Essay on Budget of a Company | Essays | Accounting

Read this essay to learn about:- 1. Introduction to Budget 2. Long Range Planning and Master Budget 3. Advantages of Budgets 4. Types of Budgets 5. Kaizen Budgeting 6. Zero Based Budgeting.

Essay # 1. Introduction to Budget:

A manager may have many good ideas. But implementation of those ideas require proper planning. You would understand it is no one time exercise. The planning horizon varies from one day to many years, depending on the objectives of the organization and the uncertainties involved.

An organization may be well equipped in advanced technology and resourceful for having a galaxy of intelligent managers, but it may not achieve success unless it sets the objectives clearly and plan its activities accordingly. Even if the objectives are set, an organization may not able to achieve them for want of proper plan.

A budget is the quantitative expression of plans — it expresses the plan in terms of physical units or monetary units. Budget gives the target to be achieved.

Not only a big business entity or government of the country needs a budget, it is essential for a very small business unit or even for a family.

In the context of a business organization, budget is the integral part of strategy and tactics. Strategies mean designing objectives and tactics are the ways of achieving the strategic goals.

Essay # 2. Long Range Planning and Master Budget:

Planning horizon of a ‘going concern’ usually involves two dimen­sions:

(i) Long range planning and

(ii) Master budget.

(i) Long Range Planning:

Long range plan is the blue prints of targets to be achieved within a five to ten year period.

It includes decisions to:

1. Design and location of new plants.

2. Diversification of products-line.

3. Acquisition of business.

4. Spin off.

Prof. Horngren et. al has explained that “long range planning produces forecasted financial statements for five or ten years”. These plans are co­ordinated through capital budgets, which detail out investment plans in land building, plant and machinery, furniture, etc. and means of financ­ing thereof.

(ii) Master Budget:

A master budget is an extensive analysis of the first year of long range plan. It is the summary of sales, production, production expenses, administrative expenses, selling and distribution expenses and research and development expenses. Prof. Horngren et al has explained that a “master budget is a periodic business plan that includes a co-ordinated set of detailed operating schedules and disbursements”. Master budget includes sales forecasts and forecasting of expenses and receipts as well as disbursement of cash.

Continuous Budget:

It is a variant of master budget by which a month’s budget is added as one month ends. So always a 12 monthly target is set. It is also called rolling budget.

Components of Master Budget:

Usually a master budget of manufacturing companies of the following components:

i. Sales budget

ii. Production budget

iii. Purchases budget

iv. Wages budget

v. Cost of goods sold budget

vi. Administrative expenses budget

vii. Selling and distribution expenses budget

viii. Cost of sales budget

ix. Profit and loss budget

x. Budgeted balance sheet

xi. Cash budget.

Essay # 3. Advantages of Budgets:

Budget has the following distinct advantages:

i. Budget fixed up the target in physical and financial terms. This helps the managers to understand the responsibilities precisely by which they can take decisions to attain the set targets. This over­comes back of objectives or direction by which the managers would have wasted resources and time.

ii. Budget helps to co-ordinate the efforts of various divisions and departments. It is possible to fix up the divisional or departmental targets and thus all divisions/departments may work harmoni­ously avoiding working for cross purposes.

iii. Budget fixes up control yardsticks. Performance of various manag­ers, divisions/departments is evaluated against the budget. This is done by finding out the difference between budgets and actuals, which is termed as budget variance and analysing the reasons thereof.

Essay # 4. Types of Budget

i. Activity Based Budgets:

Decomposi­tion of functions into various activities and sub-activities is the principal concept of activity based costing. The idea is extended to budgeting also. Budgets are prepared for each cost drivers. However, activity based budgeting is done only for the indirect costs.

Four key steps in activity based budgeting are:

1. Budgeting time spent per unit of production at each stage of cost driver and for the whole activity;

2. Total demand for the time per each cost driver and the whole activity on the basis of sales and production budgets;

3. Computation of budgeted cost of performing each activity; and

4. Computation of budgeted cost of all the activities involved in the process of production and sales.

ii. Sales Budget:

You can prepare sales budget taking monthly sales forecast multiplied by selling price.

iii. Production Budget:

Adjust with sales opening and closing stock to get production budget.

Since Speciality Auto follows a policy of fixed units of production per month, and in this example closing stock is derived using:

Production + Opening Stock – Sales = Closing Stock

iv. Material Requirement Budget:

You need to study the company’s raw material holding policy and output – input ratio. Raw material inventory policy: The company follows a policy of main­taining 2 weeks raw materials in stock to facilitate smooth production process.

Output – Input ratio 90%

So 50% of the material requirement of a month should be the opening stock and 50% of next month’s requirement should be the closing stock. Since production per month is fixed, opening and closing stock are the same.

Therefore, material requirement and purchases also remain constant.

v. Production Cost Budget:

Various Components of production cost budget are presented below:

Notes:

(i) Direct material = Material requirement × Per unit material cost

(ii) Direct labour = Production units × Labour cost per unit of produc­tion

(iii) Direct expense = Production units × Expense per unit of produc­tion

(iv) Factory overheads = Rs.200000 Fixed plus Re. 1 × production units.

(v) Administrative overhead is fixed Rs.200000

(vi) Selling distribution overhead = Rs.80000 + Rs.2 per unit sold

(vi) Closing stock of finished goods is valued at weighted average cost.

vi. Financial Budgets:

Financial budgets include:

a. Budgeted profit and loss account:

This has already been presented along with production cost budget.

b. Budgeted balance sheet:

This is estimated cash flow report against which actual cash flow is compared.

c. Cash budget:

Cash budget reflects the cash inflows and outflows arising out of operations, investment and financing activities. We have already learnt the technique of preparation of historical cash flows. Let us learn the technique of preparation of budget. Cash budget is projected cash flows. Cash budget is generally prepared on monthly basis. For the purpose of our example, we shall prepare cash budget on monthly basis.

d. Working capital budget:

Different components of working capital are:

Raw material stock, Finished goods stock, Debtors

v. Flexible Budget:

Flexible budget is a budget that adjusts the costs and revenues to actual level of capacity utilisation. The objective is to facilitate proper comparison of budget and actuals. To the contrary a static budget is prepared with reference to a particular capacity level.

Let us take an example. A company has prepared static budget at 50% capacity level and then it has compiled and finally compared the actuals with the budgets for understanding the variances.

The comparison of budget with actuals is not much meaningful. This is because, the budget was prepared for 50% capacity the actual level of capacity utilisation is 80%. The flexible budget is a proper approach for performance evaluation in the above situation. The difference between static budget and flexible budget is termed as flexible budget allowance.

Illustration 1:

On the basis of the following information prepare flexible budget.

Notes:

(1) Sales are adjusted at various capacity level with reference to 100% capacity.

(2) At a higher level of capacity utilisation it is possible to reduce the selling price.

(3) Per unit variable cost is a constant.

(4) Fixed cost increases @2% on the original level of fixed cost for every range of 10% capacity.

Incremental Cost Analysis:

Incremental revenue = Sales at the current capacity level – Sales at the previous capacity level.

Incremental cost = [Fixed cost + Variable cost at the current capacity level] – [Fixed cost + Variable cost at the previous capacity level]. Incremental Profit = Incremental Revenue – Incremental Cost.

Decision Rule:

Expand Capacity if Incremental Revenue > Incre­mental Cost.

We may continue with flexible budget example with a relatively lower level of selling price at higher capacity utilisation. See how incremental analysis helps in decision making.

So the company should not expand beyond 90% capacity level.

Essay # 5. Kaizen Budgeting:

It is a Japanese approach that project costs on the basis of future improvements rather than current practices. For this purpose, existing practices are analysed to identify potential product and process im­provements. Accordingly, the resource requirements including staff is assessed. Budgets are prepared for giving effect to the accepted im­provements.

The Kaizen budgeting is followed by Toyota Motor Co. of Japan. The budgeting process starts when top management determines a target operating income for the coming year and calculates an estimated operating income based on the company’s existing revenue and cost structures. The target operating income is generally more than esti­mated operating income. The difference is called “Kaizen Value”. Kaizen value can be achieved either by higher sales or by cost reduction.

Under the Toyota system the divisional managers submit detailed “Kaizen activity plans”. Suggestion from improvement can come from employees in all parts of the organization. A successful organiza­tion creates environment that encourages all employees to make sugges­tions.

Essay # 6. Zero Based Budgeting:

Zero based budgeting (ZBB) is defined as a method of budgeting whereby all activities are evaluated each time a budget is set. Discrete levels of each activity are valued and a combination chosen to match funds available.

The traditional budgeting is account oriented. While formulating the budget past levels are considered and then they are adjusted for inflation and new plans.

But ZBB about rethinking about past level of activities. Under ZBB all activities are studied and their effectiveness is considered with reference to objective set. For a profit making company, the outcome of each activity is assessed with reference to its contribution.

Activity based cost management (ABCM) is a technique which helps in installation of ZBB.

For example, the activities or cost drivers of a purchase department may be follows:

Last year Purchase Department’s budget was Rs.50 lacs. So this year its budget should be plus 20%, ie., Rs.60 lacs. This is traditional budgeting.

To the contrary, ZBB emphasises on justification of manpower and other resource plans of every department for all its activities with reference to the expected volume of work to be handled. This helps to locate idle capacity, idle manpower and idle resource which can be utilised in a better manner.

ZBB offers a scope for efficient resource utilisation, cost reduction and increase in profitability.

Now let us have a relook into Purchase Department’s Budget:

To the contrary, ZBB requires further analysis of staff pattern, work load and standardisation of placing purchase order. It attempts to curtail late order, better vender selection and minimising later order situation. By this one may reduce the level of spending.

By that current budget through ZBB may appear as follows:

But ZBB cannot reduce the cost indefinitely. The cost reduction effect of ZBB at the early stage is very high. Once the system is installed, one should not expect dramatic cost reduction every year.

Illustration 2:

Anami Steel Ltd. provides the following information for the months of January, 1999 – April,1999. Cash in hand and at bank as on 01.02.1999 Rs.200000.

Cash sales to total sales 20%. Cash purchases to credit purchases 20%. Credit period offered to customer is 1 month. Payment period offered by supplier is 15 days. Purchases are evenly distributed throughout the month. Wages are paid fortnightly. Salaries are paid on the last day of the month. Other expenses are met in the immediately next month.

The company declared dividend @ 40% on equity share capital of Rs.4000 thousand (calls in arrear Rs. 200 thousand) for the year 1997-98 which was paid in the month of January 1999. The company paid interest on 12% Debentures Rs.5000 thousand every March and September. Interest on loan is also payable every March and September. 1/5 of Debentures are redeemed at the end of February along with interest due.

Fixed asset costing Rs.40000 accumulated depreciation Rs.25000 was sold at a loss of Rs.5000 in March.

Prepare Cash Budget for the months of Feb-April 1999.

Solution: