Accounting (9706) | Budgeting and budgetary control

A-Level Accounting (9706): Study Notes on Budgeting and Budgetary Control (Topic 4.3)

Hello future accountants! This chapter takes you deep into the heart of management accounting: planning and control. Think of budgeting not just as numbers, but as the blueprint and scoreboard for a business. Mastering this topic is essential for A-Level success, as it combines calculation with critical evaluation skills. Let's make budgeting simple!

1. Introduction to Budgeting and Budgetary Control

1.1 What is a Budget?

A budget is simply a detailed plan of action, usually expressed in numerical (quantitative) or financial terms, for a specific future period (e.g., one year).
Analogy: If you plan a party, the budget includes how many snacks (production), how much money you can spend (cash), and how many people will attend (sales).

1.2 What is Budgetary Control?

Budgetary Control is the system that uses budgets to aid in the management and coordination of a business. It involves:
1. Preparing the budgets (Planning).
2. Monitoring actual performance against the budgets (Comparison).
3. Analysing differences (variances) and taking corrective action (Control).

1.3 Advantages and Disadvantages of a Budgetary Control System

A good budgetary system helps everyone pull in the same direction, but it's not without its flaws.

Advantages (The "Why Bother?"):

• Planning and Forecasting: Forces management to look ahead and anticipate problems.
• Coordination: Ensures different departments (e.g., Production and Sales) work together toward common goals.
• Communication: Clearly defines targets and expectations for managers and staff.
• Motivation: Staff are often motivated by challenging but achievable targets (especially if linked to incentives).
• Performance Evaluation: Provides a clear benchmark against which actual results can be measured.
• Resource Allocation: Helps management decide where best to spend money or allocate limited resources.

Disadvantages (The Challenges):

• Time Consuming: Preparation requires significant time and effort, potentially taking managers away from daily operations.
• Rigidity: Budgets can become too inflexible, especially if the business environment changes rapidly.
• Setting Targets: If targets are too tight, they can demotivate staff; if too loose, they lead to "slack" (wasted resources).
• Inter-departmental Conflict: Departments might fight over resource allocation (e.g., marketing wants more money than production thinks they need).

2. The Master Budget and Preparation Process

2.1 What is the Master Budget?

The Master Budget is the comprehensive summary of all the functional budgets (Sales, Production, Labour, etc.). It usually consists of the projected:
1. Budgeted Statement of Profit or Loss (Income Statement)
2. Budgeted Statement of Financial Position (Balance Sheet)
3. Cash Budget

It provides a holistic financial picture for the future period.

2.2 The Key Step-by-Step Budget Preparation Sequence

Budgeting is a sequential process. You can't plan production until you know how much you plan to sell!

1. Identify the Limiting Factor (Key Factor): The resource constraint that limits the organisation’s activity. This is the starting point for the *entire* budget process. (If Sales Demand is the limiting factor, the Sales Budget comes first. If machine hours are limited, the Production Budget comes first.)
2. Prepare the Sales Budget: (In units and revenue) - This usually sets the activity level for the entire firm.
3. Prepare the Production Budget: (In units) - Calculated based on sales demand plus desired closing inventory.
4. Prepare Input Budgets: (e.g., Purchases, Labour, Overheads) - Determined by the required production levels.
5. Prepare the Cash Budget: Forecasts cash inflows and outflows, crucial for managing liquidity.
6. Prepare the Master Budget: Compile the budgeted Statement of Profit or Loss and Statement of Financial Position.

2.3 The Effect of Limiting Factors

A Limiting Factor (or Key Factor) is anything that restricts the output or sales of a business. If the business ignores this constraint, its entire budget will be unrealistic.

Example: If a baker can only bake 100 loaves because the oven is small (oven capacity is the limiting factor), they shouldn't budget for selling 200 loaves, even if demand is high.

The budget must be built around maximising profit subject to this constraint. In examination questions, you must identify this factor first.

3. Key Functional Budgets

3.1 The Production Budget

This budget determines how many units must be manufactured. It is calculated in units, not dollars.

Production Units = Sales Units + Desired Closing Inventory Units – Opening Inventory Units

3.2 The Purchases (Materials) Budget

Once you know how many units to produce, you calculate the material needed.

Required Material Purchases = Material required for Production + Desired Closing Stock of Materials – Opening Stock of Materials

(Note: This figure is calculated in both physical quantities and then converted to cost ($).)

3.3 The Cash Budget: The Vital Tool for Liquidity

The cash budget is one of the most important budgets as it manages the firm’s lifeblood—cash flow. It forecasts future cash receipts and payments.

Structure of a Cash Budget (Monthly/Quarterly):

1. Opening Cash Balance
2. Cash Receipts: (e.g., Cash sales, collections from trade receivables, sale of non-current assets)
3. Total Cash Available (1 + 2)
4. Cash Payments: (e.g., Purchase of inventory/materials, wages, overheads, purchase of non-current assets, loan repayments)
5. Net Cash Flow (Receipts – Payments)
6. Closing Cash Balance (Opening Balance + Net Cash Flow)

Key Calculation Step: Handling Trade Receivables and Trade Payables

When budgeting, remember that sales do not equal cash receipts, and purchases do not equal cash payments, unless everything is done strictly in cash.
You must forecast the timing of cash flows based on credit terms (e.g., 60% collected in the month of sale, 40% collected the following month).

4. Fixed Budgeting vs. Flexible Budgeting

4.1 The Problem with Fixed Budgets

A Fixed Budget is based on only one single, predetermined level of activity or output.

If the actual activity level ends up being different from the budgeted level (e.g., we budgeted to make 5,000 units but actually made 6,000 units), comparing actual costs directly to the fixed budget is unfair and misleading. The comparison will show an adverse variance simply because we produced more!

Example: You budget $500 for materials to bake 50 cakes. If you bake 70 cakes, you will spend more than $500. It doesn't mean you were inefficient; it means you were more active.

4.2 Introducing Flexible Budgeting

Flexible Budgeting solves this problem. A flexible budget is prepared after the fact and is designed to show the costs and revenues that should have been incurred for the actual level of activity achieved.

The Key Benefit:

Flexible budgeting allows for a true like-for-like comparison between Actual Results and Budgeted Results at the Actual Activity Level. This provides a much better basis for control and performance appraisal.

How to Prepare a Flexible Budget Statement (Step-by-Step):

1. Identify Cost Behaviour: Separate all costs into Fixed, Variable, and Semi-variable components.
2. Calculate Variable Cost per Unit: \( \text{Variable Cost per Unit} = \frac{\text{Budgeted Total Variable Cost}}{\text{Budgeted Activity Level (Units)}} \)
3. Flex the Variable Costs: Multiply the Variable Cost per Unit by the Actual Activity Level.
4. Keep Fixed Costs Fixed: The budgeted total fixed costs usually remain the same across a relevant range (unless there is a stepped cost change).
5. Calculate the Flexible Budget Total: Sum the flexed variable costs and the fixed costs.

The resulting flexible budget figure is the benchmark for control.

5. Budgetary Control and Reconciliation

5.1 Variance Analysis (Differences between Actual and Flexible Budget Data)

The core of budgetary control is explaining the differences, or variances, between what was achieved (Actual) and what should have been achieved (Flexible Budget).

We compare the Actual Cost to the Flexible Budget Cost (or Actual Profit to Flexible Budget Profit) to calculate the total variance.

Possible Causes of Differences (Variances):

• Material Prices: Were the materials purchased cheaper/more expensive than budgeted? (Price variance)
• Labour Efficiency: Did workers take more/less time than budgeted to complete the job? (Efficiency variance)
• Quality Issues: Poor quality materials or machinery breakdown may lead to more wastage (adverse material usage variance).
• Unexpected Expenses: Unforeseen repairs or price increases in utilities.
• Inaccurate Budgeting: The original budget estimates were simply wrong or out-of-date.

5.2 Reconciliation Statements

You must be able to prepare statements that formally link the budgeted figures to the actual figures using the variances (differences).

Reconciling Flexible Budgeted Profit with Actual Profit:

1. Start with the Flexible Budgeted Profit.
2. Add/Subtract the total Sales Variances (Price and Volume variances, if calculated).
3. Add/Subtract the total Cost Variances (Material, Labour, Overheads).
4. The final result should equal the Actual Profit.

Reconciliation Statements (both cost of production and profit) are vital management tools as they summarise exactly *where* the company gained or lost money compared to the performance target.

6. Behavioural Aspects and Non-Financial Factors

6.1 The Human Side of Budgeting

Budgets are created and executed by people. How managers use budgets significantly impacts employee behaviour. This is the Behavioural Aspect of Budgeting.

• Target Setting: Targets should be challenging but achievable. If targets are impossible, staff will become demotivated and ignore the budget entirely. This is called budgetary slack.
• Participation: Employees are more committed if they are involved in setting their own targets (participative budgeting) rather than having targets imposed upon them (authoritarian budgeting).
• Incentives and Motivation: Budgets often form the basis for bonus schemes. If the budget encourages short-term profit maximisation at the expense of quality or long-term growth, the incentives are poorly designed.

6.2 Significance of Non-Financial Factors

While accounting focuses on dollars and cents, real-world decisions must consider factors that aren't on the statement of profit or loss.

When making recommendations or evaluating performance based on budgets, always consider:

• Quality: Did cost savings (favourable variances) result from using cheap, low-quality materials that damage reputation?
• Customer Satisfaction: Was production rushed to meet a tight budget, leading to delays or errors?
• Employee Morale: Are managers sacrificing staff well-being to hit labour cost targets?
• Safety and Environment: Are compliance costs being cut to improve profitability?

Recommendation Tip: In evaluation questions, always include a balance. "While the adverse material usage variance is concerning financially, the company must also consider the non-financial factor of product quality before changing suppliers."