23/08/2023

CHAPTER 6
Budgeting and Forecasting

DEFINITION
 A budget is a formal written statement of management’s plans for a
specified future time period, expressed in financial terms.
 A budget is a quantitative expression of a plan of action prepared in
advance of the period to which it relates.

1
 23/08/2023

Reason for Prepare Budget

 Planning for the future – in line with the objectives of the
organisation
 Controlling costs – by comparing the plan of the budget with the
actual results and investigating significant differences between the
two
 Co-ordination of the different activities of the business by ensuring
that managers are working towards the same common goal (as stated
in the budget)
 Communication – budgets communicate the targets of the
organisation to individual managers

Reason for Prepare Budget

 Motivation – budgets can motivate managers by encouraging them
to beat targets or budgets set at the beginning ofthe budget period.
Bonuses are often based on ‘beating budgets’. Budgets, if badly set,
can also demotivate employees
 Evaluation – the performance of managers is often judged by
looking at how well the manager has performed ‘against budget’
 Authorisation – budgets act as a form of authorisation of
expenditure
 Resource allocation – especially if resources are in scarce supply.
 Framework for Responsibility Accounting – Create the targets
need to be achieved for department managers

2
 23/08/2023

Problem of Traditional Budgeting

‘Budgeting is
out of kilter ‘The extent of
Budgeting is with the “gaming the
cumbersome competitive numbers” has
and too environment risen to
expensive and no longer unacceptable
meets the levels’
needs

Beyond Budgeting vs Traditional Budgeting

Leadership
Principle

Beyond
Budgeting
Management
Process

3
 23/08/2023

Purpose – Engage and

inspire people not only
focus on short-term
financial targets

Customers – Connect Values – Govern

everyone’s work with through shared values
Leadership Principle
customer needs; avoid not through rules and
conflicts of interest regulations

Organisation – Transparency – Don’t

Cultivate a strong restric information.
sense of belonging; Engage self-regulation,
avoid hierarchical innovation, learning &
control and control
bureaucracy

Autonomy – Freedom
to act; don’t punish
everyone if someone
should abuse it

Rhythm – Rhythms &

events; not around
calendar year only

Rewards – Reward Targets – Ambitious &

relative goals; Not fixed
Management Process

shared success against

competition & cascaded

Plans and forecasts –

Performance Lean & unbiased
evaluation – Peer processes; Not
feedback; Not for rigid & political
rewards only exercises

Resource allocation –
Available as needed;
not through annual
budget allocations

4
 23/08/2023

Forecast vs Budget

10

10

5
 23/08/2023

Budgetary Process

Budget Principal
Long-term Budget
Committe budget
objectives manual
e factor

Budgets Review
Master Functional
VS Slack
Budget Budgets
Actual Budget

11

A framework for budgeting

Budget committee
 Budget committee is made up of the Chief Executive, Budget
Officer (Management Accountant) and Departmental heads (sales
manager, purchasing manager, production manager and so on).

 The budget committee is responsible for communicating policy,

guidelines to the people who prepare the budgets and for setting and
approving budgets.

12

6
 23/08/2023

Budget manual
An organisation’s budget manual sets out instructions relating to
the preparation and use of budgets. A budget manual contain the
following:
 An explanation of the objectives of the budgetary process
(purpose and meaning)
 Organisational structures (Organisation chart and Holder list)
 The principal budgets and the relationship between them
 Budget preparation (sequence and timetable)
 Procedural matters (Forms, instructions, reports...etc)

13

Principal budget factor

Factor that limits an organisation’s performance in a given period
(sales demand, availability of skilled labour, machine
capacity…etc). This is also known as the key budget factor or
limiting budget factor.

14

7
 23/08/2023

TEST YOUR UNDERSTANDING 1

A principal budget factor is:

A. The highest value item of cost

B. A factor that limits the activities of an undertaking

C. A factor common to all budget centres

D. A factor controllable by the manager of the budget centre.

15

Operating
budget
(Functional)
Establish goals
for sales and
production
personnel.

Financial Budget
(Master)
Focus primarily
on cash needs to
fund operations
16
and capital
expenditures.

16

8
 23/08/2023

 Functional budget
Establish goals for sales and production personnel. The
functional budget normally comprises:
 Sales budget
 Produciton budget
 Cost budget (Material, Labour and Overhead)
The functional budgets are basis to make master budgets.

17

Sales Budget
• It is derived from the sales forecast, which is management’s best
estimate of sales revenue for the budget period.
• Every other budget depends on the sales budget.
Budgeted Sales = Budget Unit Sales x Budgeted Unit Price

ABC Ltd
Budgetd Unit Budgeted Unit Budgeted
Sales Price (£) Total Sales(£)
Sep 2019 (actual) 700 100 70,000
Oct 2019 1,000 100 100,000
Nov 2019 800 100 80,000
Dec 2019 1,400 100 140,000
Total 3,200 100 320,000

18

9
 23/08/2023

TEST YOUR UNDERSTANDING 2

A company makes two products – A and B. The products are
sold in the ratio 1:1. Planned selling prices are £100 and £200 per
unit respectively. The company needs to earn £900,000 revenue
in the coming year.

Prepare the sales budget for the coming year.

19

Production Budget
• The production budget shows units that must be produced to
meet anticipated sales.

closing opening
Budgeted Forecast
= + inventory of - inventory of
production sales
finish goods finish goods

Example:
• If ABC Ltd has opening inventory 100 units and closing
inventory 85 units, what is the budgeted production in units?
Sales forecast is 1,000 units

20

10
 23/08/2023

TEST YOUR UNDERSTANDING 3

Newton Ltd manufactures three products, the expected sales for
each product are shown below.

Product 1 Product 2 Product 3

Sales in units 3,000 4,500 3,000
Opening inventory is budgeted as: 500 700 500
Closing inventory is budgeted as: 200 300 300

Complete the following:

A. The number of units of product 1 to be produced is
B. The number of units of product 2 to be produced is
C. The number of units of product 3 to be produced is

21

Material budgets
• Involved the material planning requirement.
• Covers the quantity and types of materials to be purchased.
• Allows the manager to have a better understanding of the cost
incurred and the wastage level of the company.

closing opening
Material Material
= + inventory of - inventory of
purchases used
material material

Example:
• If material usage is budgeted to be 63,000 units, opening inventory
4,000 units and closing inventory 8,500 units, what is the budgeted
purchases in units?

22

11
 23/08/2023

TEST YOUR UNDERSTANDING 4

Newton Ltd manufactures three products and three types of
material are shown below:
Product 1 Product 2 Product 3
Budgeted production in units 2,700 4,100 2,800
Material M1 2 kg 3 kg 4 kg
Material M2 3 kg 3 kg 4 kg
Material M3 6 kg 2 kg 4 kg
Material prices are expected to be 10%higher than this year and
current prices are £1.10/kg for material M1, £3.00/kg for material M2
and £2.50/kg for material M3.
M1 M2 M3
Opening inventory 4300 3700 4400
Closing inventory 2200 1300 2000

23

TEST YOUR UNDERSTANDING 4

A. Complete the following.

I. The quantity of material M1 to be used is
II. The quantity of material M2 to be used is
III. The quantity of material M3 to be used is
B. Complete the following.
I. The quantity and value of material M1 to be purchased is
II. The quantity and value of material M2 to be purchased is
III. The quantity and value of material M3 to be purchased is

24

12
 23/08/2023

Labour Budget
• Refers to the human planning in an organization.
• Help the organization to planned ahead of the manpower
requirement thus making arrangement as and when there is any
shortage of labour.
• Allows the company to understand better its capacity because
labour hours could be said to be constraint for the production
of an organization.
Budgeted direct Budgeted direct Direct labour hour
= x
labour cost labour hours rate

25

TEST YOUR UNDERSTANDING 5

Newton Ltd manufactures three products, the expected production
levels for each product are shown below:

Product 1 Product 2 Product 3

Budgeted production in units 2,700 4,100 2,800
Skill labour (hours per unit) 3 1 3
Semi-Skill labour (hours per unit) 4 4 2

Skilled labour is to be paid at the rate of £9/hour and semi-skilled

labour at the rate of £6/hour. Complete the following.
A. The number of hours and value of skilled labour required is
B. The number of hours and value of semi-skilled labour required is

26

13
 23/08/2023

TEST YOUR UNDERSTANDING 6

A contract cleaning firm estimates that it will take 2,520 actual cleaning
hours to clean an office block. Unavoidable interruptions and lost time
are estimated to take 10% of the workers’ time. If the wage rate is £8.50
per hour, the budgeted labour cost will be:
A. £19,278 B. £21,420 C. £23,562 D. £23,800

27

Overhead Budget
• Normally, Overhead budget is setted based on direct labour
hours budget including variable overhead and fixed overhead.

Budgeted Budgeted direct Variable OVH

= x
variable OVH labour hours rate
Budgeted fixed Budgeted direct
= x Fixed OVH rate
OVH labour hours

Note:
• Fixed overhead budget unchange when assumption volume of
output change.

28

14
 23/08/2023

TEST YOUR UNDERSTANDING 7

Newton Ltd manufactures three products, the expected production
levels for each product are shown below.

Product 1 Product 2 Product 3

Budgeted production in units 2,700 4,100 2,800
Skill labour (hours per unit) 3 1 3
Semi-Skill labour (hours per unit) 4 4 2

Production overheads per labourhour are as follows:

Variable £3.50 per labour hour
Fixed £5.50 per labour hour
Calculate the overhead budget.

29

 Master budget
The master budget is the budget into which all subsidiary
budgets are consolidated. The master budget normally comprises:
 Budgeted profit or loss account
 Budgeted balance sheet
 Budgeted cash flow statement (cash budget).
The master budgets will be drawn up after all the functional
budgets have been approved.

30

15
 23/08/2023

Budgeted P/L statement

• The budgeted income statement is the important end-product
of the functional budgets.
• Indicates expected profitability of operations.
• Provides a basis for evaluating company performance.
• Prepared from the functional budgeted we did before:
+ Sales budget
+ Direct materials budget
+ Direct labor budget
+ Manufacturing overhead budget
+ Selling and administrative budget

31

Cash budgeted
• The cash budget shows anticipated cash flows.
• Often considered to be the most important output in preparing
financial budgets.
• When employees, suppliers or lenders cannot be paid, failure is
usually imminent.
• Running out of cash, even for a couple of months, will fail,
despite the fact that it is basically profitable.
• The cash budget is affected & set by the majority of budgets.

32

16
 23/08/2023

Balance sheet
• The budgeted balance sheet will show the likely financial
position at the end of the budget period.
Total assets = Liabilities + Owner equity

33

 Standard costing and flexible budget

Standard costing is the practice of substituting an expected cost for
an actual cost in the accounting records. Standard costs are
predetermined unit costs, which companies use as measures of
performance.

Distinguishing between standards and budgets:

+ Both standards and budgets are predetermined costs, and both

contribute to management planning and control.

+ A standard is a unit amount, whereas a budget is a total amount.

34

17
 23/08/2023

 Standard costing and flexible budget

• A Fixed Budget is a budget designed to remain unchanged
regardless of the volume of output or sales achieved.

• Infact, budgeted assumptions of level of output can be change

or actual volume of output can be diffirence to budget. In this
case, we need adjust fixed budget. A Flexible Budget is a
budget designed to change as volumes of output change.

Performing a sensitivity analysis

35

Participation in the budget process

Managers may be involved in setting budget targets or these
may be imposed by senior management without consultation.
Top down budget
 A budget that is set without allowing the ultimate budget
holder to have the opportunity to participate in the budgeting
process. Also called ‘imposed’ budget, or non-participative.
Bottom up budget
 A system of budgeting in which budget holders have the
opportunity to participate in setting their own budgets.Also
called participative budgeting.

36

18
 23/08/2023

Participation in the budget process

Advantages Disadvantages
 Increased motivation  Senior managers may loss
 Contain better information, of control
especially in a fast-moving  Budgets NOT match
or diverse business corporate objectives
 Increases managers’  Preparation is slower
understanding and  Propensity creat
commitment ‘Budgetary slack’
 Better communication  Certain environments
 Senior managers can may preclude
concentrate on strategy participation

37

 Alternative approaches to budgeting

There are a number of different types of budget which are all prepared
in different ways. Some of the more common budgets are as follows.

 Types of budget

TYPES OF
BUDGET

Rolling Incremental Zero-based

budget budget budget

Prepared a year Was built by adds The budgeting

ahead and update ‘increments’ in the process starts from
by adding month, previous period’s 0 because it does
quarter when first budget if it sees not take anything
period has expired necessary for granted

38

19
 23/08/2023

 Alternative budget structures

BUDGET
STRUCTURES

Product based Responsibility Activity based

budgets based budgets budgets

where individual where budgets where budgets

budgets are are produced for are based on the
produced for areas of personal activities which
each product. responsibility. drive costs.

39

Forecast
• A forecast is a prediction of what is likely to happen in the
future, given a certain set of circumstances.
• In order to prepare budgets, historic data is often used to
predict future costs and revenues.

40

20
 23/08/2023

Linear relationships
A linear relationship can be expressed in the form of an equation
that has the general form Y = a + bX, where:

• “Y” is the dependent variable, its value depend on the value of “X”

• “X” is the independent variable, whose value helps to determine the

corresponding value of “Y”

• “a” is a constant, a fixed amount in each period

• “b” is the coefficient of “X” (that is, the number by which the value
of “X” should be multiplied to derive the value of “Y”)

41

Y axis

Y = a + bX
(Linear function)

Gradient of
‘a’ line = ‘b’

X axis
0

42

21
 23/08/2023

Cost estimation
A number of methods exist for analysing semi-variable costs
intotheir fixed and variable elements. The two main methods are:

 High-low method – estimates fixed and variable costs of a

product/service

 Least squares regression – establishes a cost equation.

43

High-low method
The high-low method is based on an analysis of historical information
about costs at different activity levels. The steps involved in the high-low
method are as follows:

Step 1 – Select Highest and Lowest point

• Select the highest and lowest activity levels, and their associated costs

Note: do not take the highest and lowest costs

Step 2 – Find the variable cost per unit

𝐃𝐢𝐟𝐟𝐞𝐫𝐞𝐧𝐭 𝐜𝐨𝐬𝐭 𝐚𝐦𝐨𝐮𝐧𝐭

𝐕𝐚𝐫 𝐜𝐨𝐬𝐭 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭 𝐛 =
𝐃𝐢𝐟𝐟𝐞𝐫𝐞𝐧𝐭 𝐥𝐞𝐯𝐞𝐥 𝐨𝐟 𝐚𝐜𝐭𝐢𝐯𝐢𝐭𝐲

44

22
 23/08/2023

High-low method
Step 3 – Find the fixed cost

• Find the fixed cost by substitution, using either the high or low
activity level.

𝐅𝐢𝐱𝐞𝐝 𝐜𝐨𝐬𝐭

= 𝐓𝐨𝐭𝐚𝐥 𝐜𝐨𝐬𝐭 𝐚𝐭 𝐇𝐢𝐠𝐡𝐞𝐬𝐭 𝐋𝐨𝐰𝐞𝐬𝐭 𝐩𝐨𝐢𝐧𝐭 − 𝐓𝐨𝐭𝐚𝐥 𝐯𝐚𝐫𝐢𝐚𝐛𝐥𝐞 𝐜𝐨𝐬𝐭

45

TEST YOUR UNDERSTANDING 1

MK ltd has manufacturing cost and units show below:

Output (Units) Total cost (£)
200 7,000
300 8,000
400 9,000

Required:

A. Find variable cost per unit. B. Find total fixed cost.

C. Estimate total cost of 350 units. D. Estimate total cost of 600 units.

46

23
 23/08/2023

TEST YOUR UNDERSTANDING 2

The total costs incurred at various output levels in a factory

have been measured as follows:

Output (units) 26 30 33 44 48 50
Total cost (£) 6,566 6,510 6,800 6,985 7,380 7,310

Using the high-low method, analyse the total cost into fixed
and variable components.

47

Linear regression – Line of best fit

Consider the data which relates to the total costs incurred at
various output levels. If these data are plotted on a graph, such a graph
is known as a scattergraph or a scatter chart.

Y axis

10000

8000

6000

4000

2000
0 X axis

48

24
 23/08/2023

Linear regression – Line of best fit

 A scattergraph can be used to make an estimate of fixed and variable
costs by drawing a ‘line of best fit’ through the points which
represents all of the points plotted.
 The line of best fit has been added to the scattergraph shown above.
 The line of best fit is a cost equation (or linear function) of the form
Y = a + bX where a = fixed costs and b = variable cost per unit.
 A technique known as regression analysis can be used to establish
the equation of the line of best fit, and therefore, the fixed and
variable costs

49

TEST YOUR UNDERSTANDING 2

The total costs incurred at various output levels in a factory

have been measured as follows:

Output (units) 26 30 33 44 48 50
Total cost (£) 6,566 6,510 6,800 6,985 7,380 7,310

Using the linear regression method, analyse the total cost into
fixed and variable components.

50

25
 23/08/2023

 Correlation
 Two variables are said to be correlated if a change in one
variable brings about a change in another variable.
• Correlation measures the strength of the connection between two
variables.
• One way of measuring ‘how correlated’ two variables are is by
drawing a graph to see if any visible relationship exists.
 When correlation is strong, the estimated line of best fit should
be more reliable.
 Another way of measuring ‘how correlated’ two variables are
is to calculate a correlation coefficient, “r”, and to interpret
result.

51

Perfect positive linear Perfect negative linear

52

26
 23/08/2023

No correlation Non-linear correlation

53

 The correlation vs Causation

Two variable
have
correlation

Causation
Relationship
between two
variable is
cause-effect

54

27
 23/08/2023

 The correlation coefficient

 The extent of the correlation is the correlation coefficient
(R). ‘R’ Measures the strength of a linear relationship between
two variables.
 If we were to calculate the associated correlation
coefficient. The correlation coefficient can only take on values
between –1 and +1.
• R = + 1 indicates perfect positive correlation
• R = 0 indicates no correlation
• R = –1 indicates perfect negative correlation

55

 Coefficient of determination
The coefficient of determination is the square of the correlation
coefficient. and so is denoted by R2.
 The coefficient of determination is a measure of how much of
the variation in the dependent variable is ‘explained’ by the variation
of the independent variable.
 The variation not accounted for by variations in the independent
variable will be due to random fluctuations.

56

28
 23/08/2023

TEST YOUR UNDERSTANDING 3

The linear function y = 5,587 + 34.77x is plotted (as a ‘line of best fit’).
The associated correlation coefficient was calculated to be 0.957.
What is the coefficient of determination and
determine what that means?

57

Linear regression VS High - Low

High-Low method
Linear regression method
Easy but only takes account
All data points are taken into
of two sets of data, which
account when calculating a
may not be wholly
and b but Difficult.
representative.

58

29
 23/08/2023

 Time series analysis

• A time series is a series of observations recorded over time. Any
pattern found in the data is assumed to continue into the future and a
forecast is produced (Equation was created by using time as
independence variable).

• There are four components of a time series: trend, seasonal

variations, cyclical variations and random variations.

59

 Time series analysis

TREND ANALYSIS

• The trend is the long-term underlying movement in the data

• One way of finding the trend is to use moving averages

• A moving average is an average of the data of a fixed number of

periods. The aim of calculating moving averages is to remove the
effect of seasonal variations, for use in forecasting long-term trends

60

30
 23/08/2023

 Time series analysis

SEASONAL ANALYSIS
• Seasonal variations are short-term patterns that occur during different
periods, such as rush hour during the day, weekdays during the week,
or warmer months of the year.
• Forecasts can be made by calculating a trend line and adjusting for
seasonal variations. Seasonal variations can be estimated using:
Additive model: TS = T + SV
or
Multiplicative model: TS = T × SV
Where TS = actual time series, T = trend, SV = seasonal variation.

61

 Time series analysis

NOTE

If the trend is increasing or decreasing over time, the multiplicative

model produces more accurate forecasts than the additive model. This
is because, if the trend is increasing or decreasing, seasonal variations
are likely to be increasing or decreasing too. The additive model simply
adds an unchanging figure to the trend figures

62

31
 23/08/2023

 Time series analysis

CYCLICAL & RANDOM

• Cyclical variations: Cyclical variations are long-term patterns such

as economic booms and recessions. In practice, they are difficult to
predict and model.

• Random variations: Random variations are the product of

randomness and so cannot be predicted.

NOTE

Cyclical variations are difficult to predict and random variations are

impossible to predict. They are therefore excluded from the models

63

 Time series analysis

ASSUMPTION OF TIME SERIES ANALYSIS

 It assumes that what has happened in the past will continue to

happen in the future.

 It assumes a linear trend relationship exists.

 Seasonal variations are assumed to be constant or proportional to

the trend line.

64

32
 23/08/2023

Big Data, data analytics and data mining

• It is the data that is obtained in addition to the traditional
management information data

Example: key words discussed in published social media

conversations, or trending clips, social media.

• It therefore provide a deeper understanding of customer’s needs.

65

 CHARACTERISTIC of BIG DATA

Volume
Velocity
The scale of information
Timeliness is a key factor in
which created and stored is
the usefulness of information
staggering

BIG DATA

Veracity
Variety
The challenge is keeping the
Big data consists of structured information
and unstructured data
'clean' and free from bias

66

33
 23/08/2023

Big Data, data analytics and data

DATA DATA

ANALYTIC MINING
• Identify
• Process generate relationships
trends and aid between different
decision making items from BIG
from BIG DATA DATA
mining

UNSTRUCTURED STRUCTURED
DATA
DATA
• Data that is
pictures,videos, • Data that is
webpages, emails contained within a
or blogs field in a record or
file

67

BIG DATA BENEFIT BIG DATA PROBLEM

 Allows a substantial amount of  A company needs to be seen as trust
information to be processed, from worthy to attract customers to share
many different sources this information

 Allows an accurate model of future  Lack of forecasting tools available

demand to be generated
 Infringement on privacy
 Provides companies with the ability
 Security required to hold
to understand customer’s preferences
Information
and reactions to new Products
 Incorrect data
 Big Data can be used for short term
and long term decisions  Lack of skilled data analysts to
successfully use Big Data
 Big Data often provides ‘real’ time
information – which means it can be
continually updated

68

34
 23/08/2023

Data bias and Professional

Selection
bias

Confirma- Self-
tion selection

Scepticism
Survivorship

Observer
Cognitive
bias

Omitted
variable

Data is biased when it is not representative of the population

Reason for bias:

69

35