CHAPTER 3: Decision-making based on budgeting and expenditure forecasting

CHAPTER 3

LEARNING UNIT 15: Budgeting and budgetary control

ASSESSMENT CRITERIA
After working through this learning unit, you should be able to
• explain the purpose of budgeting and identify how it fits into the planning and control framework
• explain what responsibility centres are
• identify and describe the stages in the budgeting process and budget administration
• discuss the different budgeting approaches
• describe the criticism against incremental budgeting
• explain the difference between operational and financial budgets
• prepare basic operational and cash budgets
• prepare a flexed budget
• calculate volume and price/cost budget variances

You should spend approximately 6-7 hours on mastering the learning outcomes of this Learning Unit.

15.1 INTRODUCTION

The planning process typically begins with a strategy planning session by senior management,
culminating in a long-term (5-10 years) plan, which is then broken down into short-term operational
plans, usually per year. The annual operational plan contains the short-term objectives and targets of
how management decisions will be implemented in that year and, flowing from the operational plan,
budgets for the year are prepared and implemented to provide lower-level managers with the
necessary resources to execute the operational plan. A budget is the financial expression of the
company’s plans for achieving its stated goals and objectives. A company does not possess unlimited
cash resources and the process of budgeting will assist management in deciding which assets and
operations should take precedence for funds allocation. A well-prepared budget will indicate if surplus
cash will be generated in the budget period or whether external funding will be required to fund the
operational plan.

A budget can be prepared for any period; a long-term budget is often prepared to assess the feasibility
of the entity’s strategic plan. Detailed, operational budgets are prepared and documented for shorter
periods, usually one year. These shorter-term budgets can be used as a control mechanism to
measure actual financial performance against budgeted targets. Differences between actual
performance and budgeted targets are investigated, where required, corrective action is taken.

The process therefore starts with the strategic plan, which plan is broken down into shorter-period,
operational plans. Operational plans are communicated throughout the organisation for coordination
of the allocation of financial resources to give effect to the operational plans. Actual performance is
controlled by regular monitoring against budgeted performance; differences, if deemed material, are
investigated and corrective action taken. The process of finding significant deviations from planned
targets which managers then investigate with the purpose of eliminating the problem, is called
management by exception.

15.2 BUDGETING PROCESS

15.2.1 Responsibility accounting

To achieve the objectives set out in the operational plan and its accompanying budget, the efforts of
managers at all levels of the organisation must be coordinated. This means that some responsibility
must be delegated to lower-level managers so that they can be held accountable for the performance
of their area of responsibility. The organisational structure is important in the delegation of authority.

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In a responsibility accounting system, managers at all levels are put in charge of a responsibility centre,
i.e., a part or segment or department in the organisation; managers of responsibility centres are
accountable for the performance of their centres. Each responsibility centre will have its own budget.
The aim of responsibility accounting is that managers at all levels work towards achieving the
company's goals with minimum direction and control. This means that the organisation's structure is
arranged in lines of responsibility where every manager is responsible for a part or segment of the
organisation. There are four types of responsibility centres:

Cost centres: where managers are responsible for costs only, e.g., the production planning and
scheduling department and the HR department.
Revenue centres: where managers are responsible for revenues earned, e.g., the sales department.
Profit centres: where managers are responsible for both the revenues and costs of a segment of the
organisation, e.g., branch offices and the staff canteen.
Investment centres: where managers are responsible for investments as well as revenues and costs,
e.g., a subsidiary company.

In order to hold managers accountable for their responsibility centres, responsibility accounting is
based on the principle of controllability. Managers are held accountable for only those events and
costs that they can control; they are not held accountable for events and costs over which they have
no control. Responsibility accounting also involves the setting of performance targets and the
participation of managers in their target-setting.

15.2.2 Stages in the budgeting process

All the individual budgets prepared by managers of responsibility centres are ultimately consolidated
into a single, master budget. The master budget consists of an operating budget and a financial budget.
The operating budget is made up of the budgeted statement of comprehensive income and all the
budgets that affect the profit or loss of the organisation, i.e., the sales budget, the production budget,
and the expenses budget. The financial budget consists of the budgeted statement of financial
position, the budgeted statement of cash flows and all the budgets affecting the assets and liabilities
of the organisation, e.g., the capital budget and the cash budget. We shall return to operating and
financial budgets presently.

The important stages in the budgeting process are the following:

Communicate details of budget policy and guidelines
The long-term planning process is the starting point in the preparation of a company’s annual budget;
it provides the framework within which the budget is prepared. The implications of that plan must be
communicated to the people who prepare the budget (managers of responsibility centres and
accountants). This communication is a ‘top-down’ process. Cost-volume-profit (CVP) analysis plays
an important role in determining whether the initial profit targets will be achieved.
Identify limiting factors
Company performance can be restricted through limiting factors. Often potential sales are the limiting
factor, but it could also be things such as the availability of raw materials or the availability of skilled
labour, or a restriction of production or storage capacity. This stage in the budgeting process requires
the identification of factors that might restrict or limit performance. You will learn more about optimising
limiting factors later in this study guide. For now, it is important to realise that the objectives of any
organisation are, in effect, designed around their limitations.
Preparation of sales budget
On the assumption that sales demand restricts output, sales volumes and mix will determine the level
of operations and the sales budget is therefore prepared first. After the demand for the number of units
per product and the profit target are determined, a sales budget is prepared (subject to production
capacity constraints and availability of materials and labour). Unit sales will determine the required
production output, resources needed, etc.

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First draft preparation of other budgets

Ideally budgets are prepared by managers responsible for achieving the targets contained in the
budget, i.e., managers of responsibility centres. This is referred to as participative (or bottom-up)
budgeting. Individual budgets are prepared based on the required sales and production output. Costs
are estimated at current levels with factors built in for inflation and due regard to supplier agreements,
trade union agreements, economic forecasts, pending legislation, etc.
Budget negotiation with line management
Prepared initial budgets are submitted through the levels of line management for approval; budgets
are negotiated and agreed upon between these levels of management. The negotiation process is of
importance in the budgeting process and can determine whether the budget becomes an effective
performance management tool or is simply a ‘paper exercise’. Negotiated budgets are then submitted
to the budget committee (see next paragraph) for approval.
Co-ordination and review of budgets
The individual budgets are integrated into a single, master budget. Any anomalies between the
budgets must be resolved and the complete budget reviewed. At this stage a consolidated capital
budget, the cash budget, the budgeted statement of comprehensive income, budgeted statement of
financial position and budgeted statement of cash flows are prepared for inclusion in the master
budget. This first draft is presented to the board of directors (BoD) for review. The BoD may revise the
company strategy which is then handed down to management for budgetary revision. The process
might repeat itself a few times before a final budget is accepted
Final acceptance of budget
After final acceptance of the consolidated budget by the BoD, the budget is loaded onto the company's
financial system for control and budget reporting purposes.
Ongoing review of budgets
The budget process involves regular comparison of budgeted targets with actual results,and identifying
causes of significant variances. This may result in modifications to the budget as the period
progresses. This stage is also referred to as budgetary control.

15.2.3 Budget administration

Suitable administration procedures must be in place to ensure that the budget process is effective. In
practice the procedures will be tailor-made to suit the requirements of the organisation, but a general
rule is that at least the following budget support structures should be in place:
A budget committee, the members of which are senior management responsible for the major
functions of the organisation, e.g., HR director, finance director, marketing and sales director. The
budget committee sets the guidelines for the preparation of individual budgets and the procedures for
negotiating and agreeing budgets. Its main task is to ensure that budgets are realistic and that they
are coordinated satisfactorily. The procedure is that managers (of responsibility centres) present their
budget to the committee for approval. If the budget is not aligned with the operational plan and/or does
not reflect a reasonable level of performance, it will not be approved and the manager will be required
to adjust the budget and re-submit it for approval. A budget officer (normally an accountant) is
appointed to incorporate individual budgets into the master budget.
A budget manual, that outlines the objectives, rules, regulations, policies and procedures involved in
the budgetary process. The manual is prepared by an accountant and will typically include timelines
of the budgeting process, highlighting due dates and persons responsible for the various budget
submissions. The budget manual should also contain ethical guidelines to be followed in setting the
budget and refer to company policies where applicable, e.g., the ethical sourcing of materials and
ethical investment of surplus funds, i.e., choosing investments based on the company's ethical code.
The investment strategy may, for example, be an exclusionary strategy, e.g., not investing in countries
known for human rights abuses, or not investing in negative impact industries, e.g., the tobacco and
firearms industry. The strategy may also be inclusionary, e.g., investing in positive impact industries,
like the sustainable energy industry. Where budgets are linked to performance management and
remuneration, managers of responsibility centres should also be cautioned to budget responsibly and
in the best interest of the company and not merely to ensure that they will earn a performance bonus.

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Accounting staff, who will circulate instructions and offer advice about budget preparation, and
provide past and other information that may be useful for preparing the budget. They also ensure that
managers submit their budgets on time.

ACTIVITY 15.1

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).

1.1 A short-term objective is a specific action that managers use to reach their long-term goals.
1.2 The strategic plan is senior management's vision of what they desire the organisation to achieve
over the long term.
1.3 Cost centres, profit centres and investment centres can all be classified as responsibility centres.
1.4 Participative budgeting allows lower-level managers to have input into the budget-setting
process.
1.5 Investment centre managers are responsible only for both the revenues and costs of their
centres.
1.6 The first stage in the budgeting process is to make a forecast of net income.

15.2.4 Budgeting approaches

There are several approaches to budgeting, and we shall briefly look at the following:

Incremental (traditional) budgeting

An incremental budget is prepared by using the previous period's budget or actual performance as a
basis and adjusting it to reflect the overall expected growth or decline of the company, e.g., increase
sales by 10% and increasing expenses by the consumer price index, or, in times of austerity, reducing
the base budget by e.g., 15% across the board. This is a common approach in organisations where
not too much time is spent on formulating the budget, or where a re-evaluation of the business is not
deemed important. This type of budgeting typically occurs when there is not a great deal of competition
in an industry, for example government departments.
Advantages of incremental budgeting
• The primary advantage is its simplicity; it is relatively simple to operate and easy to understand.
• The budget is stable, and change is gradual.
• Conflicts can be avoided if responsibility centres are seen to be treated similarly.
• Coordination between budgets is easier to achieve.
• Responsibility centres are operated in a consistent and stable manner for long periods of time.
Disadvantages of incremental budgeting
• It assumes activities and methods of working will continue in the same way resulting in past
inefficiencies being perpetuated, when in fact there may be major changes that call for significant
adjustments.
• It encourages spending up to the budget just so that the budget is maintained for the next year,
i.e., there is no incentives to reduce costs (an attitude of use it or lose it).
• There is no incentive for developing new ideas.
• Inefficiencies and budgetary slack are automatically rolled into new budgets. Budgetary slack is
when a 'cushion' is created in a budget to increase the chances of the actual performance being
better than the budget; it can be underestimating budgeted income,or overestimating budgeted
expenses.

Zero-based budgeting (ZBB)

Zero-based budgeting (ZBB) begins with the assumption that every responsibility centre starts anew,
i.e., each centre must plan and budget on a blank sheet, so to speak. ZBB requires budget managers
to justify each line of their budgets. It therefore entails identifying operational objectives and then to

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create and evaluate alternative action plans for accomplishing each objective. After an evaluation of
alternative funding levels, budget priorities are set.

Advantages of zero-based budgeting

• ZBB requires the identification of alternatives and elimination of non-key activities, e.g., should an
activity be performed in-house or should it be outsourced?
• ZBB prevents artificial inflation of budgets since activities are tied to expenses.
• ZBB can enhance communication about the strategic plan and how it can be achieved.
• ZBB can identify duplication of effort and eliminate activities where they should not be located.
• ZBB focuses attention on outputs in relation to value for money.
Disadvantages of zero-based budgeting
• The main disadvantage of ZBB is the time and complexity involved to investigate and document
the activities of responsibility centres.
• It may be difficult to justify expenditure with no immediate, tangible benefits, e.g., spending on
research and development.
• Responsibility centre managers may require significant training in the ZBB process, which further
increases the time required for each budgeting period.

Activity-based budgeting (ABB)

With activity-based budgeting (ABB), expected expenditure is based on an expected activity level, i.e.,
ABB focuses on the results that the company wishes to achieve. If, for example, the budgeted activity
level is sales turnover of R100m, then the activities required to achieve the target are identified and
funded. ABB follows a reverse process of ABC (activity-based costing). You will recall that ABC
assigns costs to activity cost pools and then uses activity cost drivers to assign the activity costs to
cost objects (e.g., units of production). With ABB, cost objects are the starting point; the budgeted
output of the cost objects (e.g., number of units of a product to be sold) determines what activities are
necessary and then the resources that are required for those activities in the budget period.

Advantages of ABB
• ABB looks at the outputs that drive costs, whereas other approaches look at the cost of inputs to
perform activities.
Disadvantages of ABB
• ABB is more expensive to implement and maintain than any of the other budgeting approaches.
• ABB is also more time consuming than the other approaches.

ZBB and ABB will be covered in greater detail in your third-year modules.

Whatever the budgeting approach is, the budget can be either a static budget or a flexible budget or a
rolling budget.

Static budgets
A static budget remains as it was finally approved by the budget committee, even if there are significant
changes from the assumptions made at the time that the budget was set. Static (or fixed) budgets are
rigid and inflexible. It is the traditional form of budgeting, where an organisation attempts to force actual
results to align with the budget as closely as possible, i.e., the budget remains fixed regardless of the
level of actual output of the company. It leads to rigidity, rather than allowing for a timely reaction to
changes in its environment. Static budgets also operate on a fixed timeframe. For example, if a static
budget is created for a 12-month period, it is the only budget used during those 12 months, and after
those 12 months a new 12-month budget is created.

Flexible budgets
A flexible budget, also known as a variable budget, is the opposite of a static budget. A flexible budget
is adjusted based on a change in the assumptions used when the budget was created. The company
prepares a flexed budget to change according to the level of output. Initially, the budget is prepared

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with a fixed level of output; once the actual level of output is determined, the budget is adjusted
accordingly. Flexible budgets can be adjusted at any time. A flexible budget allows e.g., for different
sales levels, with adjusted planned expense levels to match the sales levels. It is especially useful
when sales levels are difficult to estimate, and a significant proportion of expenses are variable with
sales levels.

Rolling forecasts
If there is one thing that Covid-19 taught us, it is that the annual budget is not agile enough to support
a constantly changing business environment. The annual budget makes certain assumptions, but
those assumptions are not changed when actual reality proves otherwise, hence the need for a flexed
budget. In contrast to a flexed budget, a rolling forecast allows for continuous planning for future
performance based on current actual performance. The rolling forecast model is a useful tool for
planning in an ever-changing business environment because it continuously extends into the future.
As soon as one accounting period has expired, a forecast for new accounting period is added, based
on the latest information available. In other words, a rolling forecast uses a drop/add approach to
continuously forecast revenue and expenses, considering actual year-to-date spending and revenues,
the original budget, current economic and market conditions, as well as any other relevant information
to make forecasts about future performance. The accounting period can be a month or a quarter, etc.
For example, if a budget is set for January 2023 to December 2023 and the accounting period for
rolling purposes is a month, then, at the end of January 2023, a budget for January 2024 will be added;
i.e., as January 2023 is dropped, January 2024 is added. By doing so, the budget always extends a
uniform distance (in this instance four quarters) into the future, as shown in Figure 15.1; in every line
the four quarters are shadowed.

FIGURE 15.1: ROLLING FORECAST

Q1 2023 Q2 2023 Q3 2023 Q4 2023 Q1 2024 Q2 2024 Q3 2024 Q4 2024 Q1 2025

Forecast Forecast Forecast Forecast
Actual Forecast Forecast Forecast Forecast
Actual Actual Forecast Forecast Forecast Forecast
Actual Actual Actual Forecast Forecast Forecast Forecast
Actual Actual Actual Actual Forecast Forecast Forecast Forecast
Actual Actual Actual Actual Actual Forecast Forecast Forecast Forecast

A well-prepared budget will focus the attention and direct the activities of all staff members to work
together to achieve the goals and objectives of the company in an effective and efficient manner. It
creates an awareness of the importance of cost control and will reveal any problem areas in a timely
manner so that corrective action can be taken.

Effectiveness and efficiency do not have the same meaning. Effectiveness is often referred to as ‘doing
the right thing’; it refers to achieving what was intended to be achieved. Efficiency is often referred to
as ‘doing the thing right’; it refers to, for example, the time it takes, and the resources required for
'doing the right thing'. You will be both effective and efficient if you are doing the right thing right.

Example 15.1

A company manufactures pillows. According to the standards set by the company, each pillow requires
75 cm x 40 cm of fabric and 500 g of feathers, as well as 30 minutes of stitching time to complete. The
budget is set to make 2 000 pillows during the month. It would therefore require 2 000 × 75 cm = 150
metres of fabric (that is 40 cm wide) and 2 000 × 500 g = 1 000 kg of feathers and 2 000 × 30 minutes
= 1 000 hours to manufacture the planned 2 000 pillows.

Assume that by the end of the month the planned 2 000 pillows had been manufactured and that 170
metres of fabric and 1 050 kg feathers were used, and that the workers had to work 1 050 hours to
make the 2 000 pillows. We say that

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• production for the month was effective, because the factory 'did the right thing'; it had made the
2 000 pillows it had set out to make.
• production for the month was not efficient, because more time and other resources were used than
planned, i.e., the factory did not ‘do the thing right’.
________________________________________________________________________________

Budgeting assists management to efficiently and effectively manage the financial resources of the
company through sound financial planning (where the financial resources will come from and how the
financial resources will be spent) and financial control. In the next paragraph we shall now look at the
different budgets, in the order in which they are prepared.

ACTIVITY 15.2

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).

1.1 Zero-based budgeting requires managers to justify all costs of planned activities as if these
activities were being proposed for the first time.
1.2 In zero-base budgeting, only changes from the prior budget must be justified.
1.3 The basic idea behind responsibility accounting is that senior management is responsible for
preparing detailed budgets by which the performance of lower-level management will be
evaluated.
1.4 A static budget is changed only when actual output is different from the level of output expected.
1.5 A continuous or perpetual budget is one which covers an e.g., 12-month period but which is
constantly adding a new month at the end as the current month is completed.

15.3 THE OPERATING BUDGET

15.3.1 Sales budget

This budget reflects income from sales and must not be confused with the budget for expenses relating
to sales. Expenses relating to sales are budgeted for in the Marketing, Selling and Distribution
Expenses Budget.

The sales budget is usually prepared first, because it informs the other operational budgets. It shows an
itemisation of the expected number of sales units for a period as well as the expected Rand-value per
unit and in total. If a company has multiple products (which is usually the case), the budget is compiled
per product category.

The information that is used to prepare the sales budget comes from a variety of sources. Most of the
information about existing products comes from staff members who deal with products on a daily basis,
for example the marketing staff will provide information about special promotions that may influence
the timing and quantity of sales, while the research & development staff will provide information about
the launch of new products and the withdrawal of old products. The preparation of the sales budget
also requires an analysis of market conditions, government policies, and the macroeconomic and
microeconomic environment in which the company operates.

It is important that the sales projections are as accurate as possible because the sales budget is used
as a basis for the preparation of almost every other budget. If the sales budget is significantly
inaccurate, all the other budgets, especially those expenses that vary with sales and production levels,
will also be significantly inaccurate.

After the sales budget has been prepared, a budget showing where the goods to be sold will come
from is prepared. A retailer will prepare a purchases budget to show the goods to be purchased for
resale during the budget period. A manufacturer will prepare a production budget. The focus of this
study guide is manufacturing organisations, so we shall proceed with the production budget.

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15.3.2 Production budget

The sales budget informs the production of how many units must be manufactured to meet the sales
demand. The function of the production budget is to ensure that sufficient inventory is always available
to meet expected sales and that inventory is kept at an optimal level. The projected unit sales
information in the sales budget feeds directly into the production budget. The number of units that must
be manufactured is equal to:
projected sales units + required units in closing inventory – units in opening inventory.

The planned levels of finished goods inventory must be very carefully considered; too many units in
inventory may lead to obsolete or damaged inventory that must be disposed of at a loss, while too little
inventory may result in lost sales. Issues such as inventory holding costs must also be carefully
considered. See Learning Unit 6.

The production budget is not really a budget in the strict sense of the word but rather a schedule of
the units that must be manufactured during a specific period. It does not contain any financial values;
the budgets for direct materials, direct labour and production overheads will contain details of the
financial requirements to meet the production needs set out in the production schedule.

15.3.2.1 Direct materials budget

Once the level of production volume has been determined, the direct materials budget is drawn up to
show the quantities of materials that will be required to meet the expected production demand during
the period, plus the planned closing inventory of direct materials at the end of that period. The direct
materials budget will therefore also show the quantities of direct materials that must be purchased.
The calculated required purchase quantities are multiplied by the expected purchase price. The
quantity of materials to be purchased is equal to:
quantity required for production + quantity required in closing inventory – quantity in opening inventory.

Depending on the type of goods manufactured, the direct materials budget may demand a
considerable portion of the company’s financial resources and should therefore be compiled with
considerable care. Refer to Learning Unit 6. A significantly inaccurate budget may erroneously indicate
excessively high or excessively low cash requirements to fund direct materials purchases.

There may be literally hundreds of different kinds of components that are used in the production of
finished goods. It would be impossible to calculate the direct materials budget for every component
and type of direct material in inventory. Most companies would use materials requirements planning
(MRP) software to determine direct materials purchases requirements; by entering the production
budget into the MRP system, the software can generate the direct materials budget.

Ethical sourcing of materials should be considered when the materials budget is prepared.

15.3.2.2 Direct labour budget

Like the direct materials budget, the direct labour budget also uses the production schedule as a
starting point. The direct labour budget shows the total number of direct labour hours (DLH) required
for production and the cost thereof. The direct labour budget can also assist management to anticipate
the number of employees that will be required during the budgeted period and so plan for possible
new appointments or overtime. Refer to Learning Unit 7. The direct labour budget is equal to the:
number of units to be manufactured × number of DLH per unit × direct labour recovery rate per hour.

Ethical HR and remuneration practices should be considered when the labour budget is prepared.

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15.3.2.3 Production overheads budget

The production overheads budget lists all the anticipated production costs, other than the cost of direct
materials and direct labour, needed to give effect to the production schedule. This budget will typically
consist of two sections: one section for variable overheads and one section for fixed overheads. This
budget also contains non-cash flow items such as depreciation; it is advisable that this budget also
indicates the expected cash flows as it will assist in the preparation of the cash budget. Refer to
Learning Unit 8 and Learning Unit 4 (separation of fixed and variable costs).

15.3.2.4 Cost of goods manufactured and sold budget

The cost of goods manufactured and sold budget summarises the expected production costs that will
be incurred to meet the budgeted production volumes and the accumulated cost of goods that will be
sold. The cost of goods manufactured and sold budget is based on direct materials purchases budget,
direct labour budget, production overheads budget and the sales budget. This budget is prepared for
the year (not monthly or quarterly) as it feeds into the budgeted Statement of Comprehensive Income
for the year.

15.3.3 Marketing, selling and distribution expenses budget

The marketing, selling and distribution expenses budget comprises period costs, such as advertising,
transport, storage, insurance, collection cost, and sales staff salaries, bonuses and commissions. For
control purposes, fixed and variable costs must be separated.

Ethical marketing and sales practices should be considered when this budget is prepared, e.g., is
undue pressure exerted on customers leading to them getting over-indebted?

15.3.4 Administration expenses budget

Period costs of senior management and the finance, IT, human resources departments, etc are
budgeted for in the administration budget. This budget does not have a direct connection with the sales
and production budgets. These costs are usually fixed as they are incurred irrespective of sales.

15.3.5 Research and development budget

Research and development costs will be incurred by any manufacturing organisation that wants to
stay ahead technologically. For this, a detailed budget is required. Research ethics must be considered
when this budget is prepared, e.g., are ethical guidelines followed when animals are used in research?

15.3.6 Budgeted Statement of Comprehensive Income

At this point a budgeted statement of comprehensive income can be prepared, based on information
in the budgets presented in paragraphs 15.3.1 to 15.3.5. This budget will be prepared by an
accountant. The budgets discussed in paragraphs 15.3.1 to 15.3.6 are collectively the operating
budget of the organisation.

15.4 THE FINANCIAL BUDGET

15.4.1 Capital budget

This budget is designed to provide for investment in new or replacement of non-current assets. This
budget is usually based on an organisation’s long-term plan to expand market share, launch new
products, etc. A consolidated capital budget will be prepared by an accountant. Ethical questions to
consider is potential greenhouse gas emissions of planned equipment purchases. You will learn more
about capital budgeting techniques in your MAC2602 module.

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15.4.2 Cash budget

Liquidity, that is, the ability to meet cash obligations, is very important in any organisation. The cash
budget is prepared when all the other budgets are completed, because it uses the information from
the other budgets as well as payment terms of both long-term and short-term creditors to forecast both
cash receipts and payments. The cash budget will be prepared by an accountant. The cash budget
will be discussed in greater detail later on.

15.4.3 Budgeted statement of financial position and budgeted statement of cash flows

The budgeted statement of financial position and budgeted statement of cash flows are prepared by
an accountant from information in the other financial budgets as well as the budgeted statement of
comprehensive income.

15.5 MASTER BUDGET

The master budget is also called the main budget. The master budget is a consolidation of all the other,
individual budgets submitted by responsibility centres and accountants and subsequently approved. A
master budget will cover all the activities in the organisation.

For the purpose of this module, designing and preparing detailed, integrated (balanced) master and
sub-budgets based on sales and production volumes are not required. However, it is essential that
you are at least able to identify the various budgets. Preparation of these will be taught in MAC3701.
You should, however, be able to produce elementary operational budgets and cash budgets as well
as determine budgeted fixed cost recovery rates.

ACTIVITY 15.3

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).

1.1 Operating budgets focus on the financial resources needed to support operations.
1.2 The direct labour budget is based on budgeted sales levels.
1.3 Budgeted production overheads include indirect manufacturing costs, but not selling or
administrative costs.
1.4 The cash budget is a detailed plan showing how cash will be acquired and used over a specific
time period.
1.5 The cash budget is developed from the budgeted statement of comprehensive income.
1.6 The usual starting point in budget preparation is to make a forecast of cash receipts and cash
disbursements.
1.7 Budgets are used for planning rather than for the control of operations.
1.8 When preparing a direct material purchases budget, desired closing inventory is subtracted from
total needs of the period to arrive at materials to be purchased.
1.9 It is essential that the cash budget is prepared before the operational budgets so that the level
of funding available for the operational budgets is known.

QUESTION 2

For each of the following questions, read carefully through the information provided and select only
the most correct option as your answer.
2.1 The … budget is not an operating budget.
(a) direct labour
(b) cash
(c) direct materials

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(d) expenses
2.2 The master budget consists of …
(a) an interrelated long-term plan and operating budgets.
(b) financial budgets and a long-term plan.
(c) interrelated financial budgets and operating budgets.
(d) all the accounting journals and ledgers used by a company.
2.3 If budgeted sales are 89 350 units, desired closing inventory is 33 156 and actual opening
inventory is 23 864 units, the production budget would be for …units.
(a) 80 058
(b) 146 370
(c) 32 330
(d) 98 642
2.4 It is not true that the …
(a) sales budget is determined by multiplying estimated sales by the selling price.
(b) production budget begins with the sales estimated for each period.
(c) direct materials budget begins with the sales estimated for each period.
(d) sales budget is typically the first budget prepared.
2.5 A … budget evaluates the results of operations at the actual level of output.
(a) capital
(b) cash
(c) flexible
(d) static
2.6 The cash budget is part of the … category of budgets?
(a) sales
(b) capital
(c) financial
(d) operating
2.7 The units to be included in the production budget are calculated by …
(a) adding budgeted sales to the desired closing inventory and subtracting opening inventory.
(b) adding opening inventory, budgeted sales and desired closing inventory.
(c) adding opening inventory to budgeted sales and subtracting desired closing inventory.
(d) adding budgeted sales to the opening inventory and subtracting the desired closing inventory.
2.8 The main difference between static and flexible budgets is the …
(a) fixed production overhead is adjusted for units sold in the flexible budget.
(b) variable production overhead is adjusted in the static budget.
(c) variable costs are adjusted in a flexible budget.
(d) There is no difference between the budgets.

Example 15.2

COMPREHENSIVE EXAMPLE OF THE OPERATING BUDGET

XYZ Ceramics buys dry powdered clay that is mixed with water in underground tanks to create a slip
(liquid clay solution). The slip is then poured into casting moulds to manufacture the finished goods that
are sold. The cost of labour to mix the powdered clay with water is considered a fixed overhead cost.

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Each final product requires the equivalent of 500 grams of powdered clay. The cost of the clay is
expected to be R12 per kg on 1 January 2023 but a price increase of R1 per kg is expected with effect
1 July 2023.

It takes one worker an average of 15 minutes to prepare one casting mould and to pour the slip into it.
Once set, it takes one worker a further 15 minutes to release the product from the mould. Once
released from the moulds, the products are left to dry naturally. Once dry, the products are put through
a finishing process to smooth away the mould line. It takes one worker 10 minutes to finish one unit.
The products are then fired in a kiln to convert the clay into stoneware. Once the products have cooled
down, artists apply the glazing and finishing touches to each unit. It takes an artist 45 minutes per unit
to complete this task. The units are then placed into the kiln again for a second firing. After the units
have cooled down from the second firing, they are labelled, wrapped and packed into individual boxes;
this process takes one worker 20 minutes per unit to complete. The wrapping and boxes are
considered indirect materials. The labour recovery rate for artists is R150 per hour and for all other
workers R80 per hour.

Anticipated sales are 4 000 units × R320; 5 000 units × R350; 5 500 × R350 and 8 000 units × R380
for each of the four quarters of 2023.

Variable production overheads are budgeted for based on direct labour hours (DLH) as follows:
R per DLH
Indirect materials 1,20
Consumables 0,90
Indirect labour 3,00
Variable portion of mixed costs 3,10

Fixed production overhead is apportioned to production based on the number of units manufactured.

The management of XYZ Ceramics has adopted the following policies:

• A first-in-first-out (FIFO) cost flow is assumed.

• Closing inventory of finished goods is to be maintained at 10% of the next quarter’s projected sales
(projected sales for the first quarter of 2024 is 7 000 units).

There was no work-in-progress at the beginning of the year. Other opening inventories on
1 January 2023 were:

• 90 kg of dry powdered clay at R11,50 per kg

• 1 000 units of finished goods at R237,30 per unit

The operational budgets of XYZ Ceramics for the financial year that will end on 31 December 2023
appear below.

Sales budget of XYZ Ceramics for the year ended 31 December 2023

Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total

Projected sales in units 4 000 5 000 5 500 8 000 22 500
Price per unit R320 R350 R350 R380
Gross sales R1 280 000 R1 750 000 R1 925 000 R3 040 000 R7 995 000

The sales budget of XYZ Ceramics shows a peak in sales in the last quarter which may be ascribed
to the festive season. The lower selling price per unit in Quarter 1 (Q1) may be a strategy to move
excess unsold inventory from the previous festive season.

Production budget of XYZ Ceramics for the year ended 31 December 2023

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Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total 

Projected sales in units 4 000 5 000 5 500 8 000 22 500
+ planned closing inventory  500 550 800 700 700
= total units required 4 500 5 550 6 300 8 700 23 200
- opening inventory  (1 000) (500) (550) (800) (1 000)
= units to be manufactured 3 500 5 050 5 750 7 900 22 200

 Closing inventory at the end of Q1 = 5000×10% (10% of Q2 projected sales); closing inventory at
the end of Q2 = 5500×10% (10% of Q3 projected sales); closing inventory at the end of Q3 =
8000×10% (10% of Q4 projected sales); closing inventory at the end of Q4 = 7000×10% (10% of Q1
of 2024 sales).
 The closing balance of Q1 will be the opening balance of Q2; the closing balance of Q2 will be the
opening balance of Q3, etc.
 The 1 000 units in opening inventory at the beginning of the year may be an indication that sales in
the last quarter of 2022 was lower than planned.
 The total column reflects the planned production for the year; 700 units is the planned level of closing
inventory on 31 December 2023 and the 1 000 units is the opening inventory on 1 January 2023.

Direct materials budget of XYZ Ceramics for the year ended 31 December 2023
Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
Production required (units) 3 500 5 050 5 750 7 900 22 200
× clay per unit (kg) 0,5 0,5 0,5 0,.5 0,5
= Total clay required (kg) 1 750 2 525 2 875 3 950 11 100
+ Planned closing inventory (kg) 250 275 400 350 350
= Total clay needed (kg) 2 000 2 800 3 275 4 300 11 450
- Opening inventory (kg) (90) (250) (275) (400) (90)
Purchases required (kg) 1 910 2 550 3 000 3 900 11 360
Cost per kg R12 R12 R13 R13
Total purchase cost R22 920 R30 600 R39 000 R50 700 R143 220

Planned closing inventory levels are in line with planned closing inventory of finished goods: at the end
of e.g., Q1 closing inventory of finished goods is planned at 500 units; if 500 grams (or 0,5 kg because
there are 1 000 grams in one kilogramme) of clay are required for each unit, then 500 × 0.5 = 250 kg of
clay will be required in closing inventory of direct materials at the end of Q1.

Direct labour budget of XYZ Ceramics for the year ended 31 December 2023
Direct labour hours required Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
Production units required 3 500 5 050 5 750 7 900 22 200
Artists (45 min: 45/60 = 0,75 h) × 0,75 × 0,75 × 0,75 × 0,75 × 0,75
Total artist hours (units × 0,75 h) 2 625 3 787,5 4 312,5 5 925 16 650
Other workers (60 min = 1 h *)
Total worker hours (units × 1 h) 3 500 5 050 5 750 7 900 22 200
Direct labour cost (R) Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
Artist hours 2 625 3 787,5 4 312,5 5 925 16 650
Cost per hour × R150 × R150 × R150 × R150 × R150
Artists' cost R393 750 R568 125 R646 875 R888 750 R2 497 500
Workers' cost R280 000 R404 000 R460 000 R632 000 R1 776 000
Worker hours 3 500 5 050 5 750 7 900 22 200
Cost per hour × R80) × R80 × R80 × R80 × R80 × R80
Total direct labour cost R673 750 R972 125 R1 106 875 R1 520 750 R4 273 500

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* Minutes
Pour into mould 15
Release from mould 15
Finishing 10
Packing 20
Total minutes 60

The labour recovery rate of all workers other than artists is R80 per direct labour hour; they can
therefore be grouped together for budgeting purposes.

Production overheads budget of XYZ Ceramics for the year ended 31 December 2023
Quarter1 Quarter2 Quarter3 Quarter4 Total
Total units of production 3 500 5 050 5 750 7 900 22 200
Total DL hours 6 125 8 837,5 10 062,5 13 825 38 850
Total artist hours 2 625 3 787,5 4 312,5 5 925 16 650
Total worker hours 3 500 5 050,0 5 750,0 7 900 22 200
Variable production overhead  R R R R R
•Indirect materials 1,20 7 350 10 605 12 075 16 590 46 620
•Consumables 0,90 5 512 7 954 9 056 12 443 34 965
•Indirect labour 3,00 18 375 26 512 30 188 41 475 116 550
•Variable portion of mixed costs 3,10 18 988 27 396 31 193 42 858 120 435
Total variable costs 8,20 50 225 72 467 82 512 113 366 318 570
 The variable overheads budget is based on a pre-determined rate per direct labour hour (DLH),
e.g., Indirect Materials budget for Q1 = 6 125 hours × R1,20 per hour = R7 350.
Fixed production overhead Quarter1 Quarter2 Quarter3 Quarter4 Total
R R R R R
•Rent 20 000 20 000 20 000 20 000 80 000
•Insurance 2 000 2 000 2 000 2 000 8 000
•Fixed labour cost 190 000 190 000 190 000 190 000 760 000
•Depreciation 6 000 6 000 6 000 6 000 24 000
•Fixed portion of mixed costs 28 000 28 000 28 000 28 000 112 000
Total fixed costs 246 000 246 000 246 000 246 000 984 000
 less non-cash items (6 000) (6 000) (6 000) (6 000) (24 000)
= Expected cash outflows 240 000 240 000 240 000 240 000 960 000

 Depreciation (and other non-cash items should there be any) is deducted from the total overheads
to obtain the figure that will be used in the cash budget.

After the production budgets are completed, the recovery rates for overheads can be determined. The
cost per unit is required to calculate the value of closing inventory of finished goods.

Calculation of cost per unit R

Direct materials (0,5 kg × R13 per kg) 6,50
Direct labour: artists (0,75 hours × R150 per hour) 112,50
Direct labour: other (1 hour × R80 per hour) 80,00
Variable production overheads
 (R8,20 per DLH × 1,75 DLH) 14,35
Total variable cost 213,35

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Fixed production overheads (R984 000÷22 200 = 44,324324) 44,32

Total assigned cost per unit 257,67

 There is a FIFO cost flow assumption, therefore closing inventories will be held at the most
recent costs in. Planned closing inventory at the end of Q4 is 350 kg and planned purchases
for Q4 is 3 900 kg; thus all 350 kg in closing inventory would be from Q4 purchases.
 Variable overheads cost per direct labour hour is R8,20 and one unit takes 1,75 hours to
complete. Therefore, the variable overheads cost per unit = R8,20 × 1,75 DLH

Cost of goods manufactured & sold budget of XYZ Ceramics for the year ended 31 December 2023

R
Opening inventory direct materials 1 035 Note 1
+ Direct materials purchases 143 220
- Closing inventory direct materials (4 550) Note 2
= Cost of direct materials used in production 139 705
+ Direct labour cost 4 273 500 As calculated above
+ Production overheads 1 302 570 Note 3
= Total manufacturing cost 5 715 775
+ Opening inventory work-in-progress 0 Note 4
- Closing inventory work-in-progress 0 Note 4
= Budgeted cost of goods manufactured 5 715 775
+ Opening inventory of finished goods 237 300 Note 5
= Goods available for sale 5 953 075
- Closing inventory of finished goods (180 369) Note 6
= Budgeted cost of goods sold 5 772 706

1 Opening inventory of direct materials = 90 kg × R11,50 = R1 035 (given)

2 Closing inventory of direct materials = 350 kg × R13 = R4 550. A FIFO cost flow assumption means
that inventory will be held at the last cost in (because first costs into inventory flow out of inventory
first, so that inventory is held at the most recent costs in).
3 As calculated above: Variable Overheads of R318570 + Total Fixed Overheads of R984 000 =
R1 302 570
4 In this example there is no work-in-progress.
5 Opening inventory of finished goods = 1 000 units × R237,30 = R237 300 (given)
6 Closing inventory of finished goods 700 units × R257,67 = R180 369 (see calculation under
production for the quantity and production overheads budget for the Rand value respectively).

Sales, distribution and administration budget of XYZ Ceramics for the year ended 31 December 2023
Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
R R R R R
Variable sales expenses: 15 360 21 000 23 100 36 480 95 940
Commission 12 800 17 500 19 250 30 400 79 950
Delivery charges 2 560 3 500 3 850 6 080 15 990
Fixed expenses: 295 000 275 000 276 000 338 000 1 184 000
Advertising 50 000 30 000 30 000 50 000 160 000
Insurance (non-manufacturing) 8 000 8 000 8 000 8 000 32 000
Rent (non-manufacturing) 12 000 12 000 12 000 12 000 48 000
Salaries and benefits 200 000 200 000 200 000 240 000 840 000
Consumables (e.g., stationery) 13 000 13 000 13 000 13 000 52 000
Travelling expenses 12 000 12 000 13 000 15 000 52 000

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Total expenses 310 360 296 000 299 100 374 480 1 279 940

Note: the Sales, distribution and administration budget above is included for the sake of completeness. The
figures in the budget are assumed.

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Budgeted Statement of Comprehensive Income for the year ended 31 December 2023

R
Sales 7 995 000 (Sales budget)
Cost of Sales 5 772 706 (Cost of goods manufactured and sold budget)
Gross profit 2 222 294
Expenses 1 279 940 (Selling, distribution and administration expenses budget)
Operating profit 942 354
________________________________________________________________________________

15.6 CASH BUDGET

The purpose of a cash budget is to monitor the flow of cash in the company, i.e., it provides estimates
of all payments and receipts for a given period and determines an organisation’s cash and cash
equivalent position. The financial statements of companies are prepared in compliance with
International Financial Reporting Standards (IFRS). In terms of the Conceptual Framework for
Financial Reporting, transactions are recorded in the accounting records according to the accrual
basis, i.e., in the period in which the transactions occur, even if the cash receipts or cash payments
relating to those transactions occur in a different period. The most obvious examples of accrual
accounting are sales and purchases transactions on account. Where goods are sold to a customer on
credit, the sales transaction is recorded as income even though the customer has not yet paid for the
goods. It is therefore possible for a company to make a profit, yet be in financial trouble as a result of
a shortage of cash.

The cash budget forecasts the monthly and year-end cash position and highlight the financial
requirements for the budget period. The company’s objectives will be jeopardised if it finds itself with
a shortage of cash and no plans for borrowing. It is essential for a company to determine if it will
generate sufficient cash from its operations to meet the budgeted cash requirements. If a temporary
cash shortfall is anticipated, management must find additional short-term funding in a timely manner.

Cash management also enables management to keep shortages within the available overdraft facility
and to invest surpluses in short-term investments that can be withdrawn at short notice when required.
You will learn more about working capital management and cash management in MAC2602. An
annualised cash budget is not sufficient for purposes of cash management. Although the opening
balance and the closing balance of an annual cash budget may both indicate a healthy cash position,
large cash outflows occurring in quick succession during the year (e.g., tax payments, dividend
payments and loan repayments) may lead to short-term cash shortages. This is why monthly cash
forecasts are preferred, although these require more information and planning. Some organisations
may even do weekly cash flow forecasts.

The cash budget consists of three sections:

• the sources of cash, i.e., where cash will come from
• the uses of cash, i.e., where the cash will go to
• the cash surplus or shortfall at the end of the budget period

We say that cash sources are cash inflows (cash flowing into the business) and uses of cash are cash
outflows (cash flowing out of the business). The cash at the end of the budget period (the amount that
will be included in the budgeted Statement of Financial Position as cash and cash equivalents) is
determined as follows: opening balance of cash and cash equivalents + cash inflows - cash outflows
= cash and cash equivalents at the end of the period.

The sources of cash include cash sales, collections (payments) from debtors and any other cash
received, e.g., interest and dividends received or the sale of non-current assets during the period. The
uses of cash include all cash payments planned for the budget period, for example, payment of
suppliers, salaries and wages, rent, and interest. Uses of cash also include capital payments, e.g.,
equipment purchases and loan repayments.

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The cash surplus or shortage section of the cash budget is calculated as follows:
Cash surplus or shortfall at the beginning of the period (for the first period this will be an actual figure)
ADD: budgeted cash inflows
SUBTRACT: budgeted cash outflows
EQUALS: budgeted cash surplus or shortfall at the end of the period

When preparing the cash budget, supporting schedules (documentation, including, but not limited to,
client lists and labour schedules) must be used. All non-cash items, such as depreciation and
amortisations, are excluded from the cash budget. This is because only transactions that influence the
company’s cash position are required.

Example 15.3

We shall continue with Example 15.2. On 31 December 2022 XYZ Ceramics had the following
balances in its Statement of Financial Position:
Bank R1 576 000
Debtors R750 000
Creditors R48 000

The following assumptions will apply in the preparation of the cash budget of XYZ Ceramics for the
year ended 31 December 2023:
• All purchases of direct materials are made on credit and creditors are paid in the quarter following
the quarter in which purchases are made, i.e., purchases made in Q1 are paid for in Q2;
• Debtors are collected in the quarter following the quarter in which sales occur. There are no cash
sales;
• All other costs are paid as incurred.

The cash budget of XYZ Ceramics for the year ending 31 December 2023 appears below. For easy
reference the following summary of the budgets from Example 15.2 is supplied:
Q1 Q2 Q3 Q4
R R R R
Sales budget 1 280 000 1 750 000 1 925 000 3 040 000
Direct materials budget 22 920 30 600 39 000 50 700
Direct labour budget 673 750 972 125 1 106 875 1 520 750
Variable production overhead 50 225 72 467 82 512 113 366
Fixed production overhead * 240 000 240 000 240 000 240 000
Period costs budget 310 360 296 000 299 100 374 480

* Excluding non-cash items

Cash budget of XYZ Ceramics for the year ended 31 December 2023
Q1 Q2 Q3 Q4
R R R R
Opening balance of cash 1 576 000 1 003 665 680 153 671 066
Cash inflows:
Collections from debtors 1 750 000 1 280 000 1 750 000 1 925 000
Total cash available 2 326 000 2 283 665 2 430 153 2 596 066
Cash outflows 1 322 335 1 603 512 1 759 087 2 287 596
Direct material purchases 2 48 000 22 920 30 600 39 000
Direct labour payment 3 673 750 972 125 1 106 875 1 520 750
Variable production overhead 3 50 225 72 467 82 512 113 366
Fixed production overhead 3 240 000 240 000 240 000 240 000
Payment of period costs 3 310 360 296 000 299 100 374 480

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Net cash position 1 003 665 680 153 671 066 308 470

1
Debtors from Q4 of 2022 are collected in Q1 of 2023: R750 000
Debtors from Q1 of 2023 are collected in Q2 of 2023: R1 280 000, etc
2
Creditors from Q4 of 2022 are paid in Q1 of 2023: R48 000
Creditors from Q1 of 2023 are paid in Q2 of 2023: R22 920, etc
3
Payment is made in the same month that the costs are incurred

The management of XYZ Ceramics must thoroughly investigate the cash position. Despite a budgeted
profit of R942 354, the cash budget indicates that cash reserves will dwindle from R1 576 000 at the
beginning of the year to only R308 470 at the end of the year. The R308 470 is unlikely to sustain
operations in the first quarter of 2024.
________________________________________________________________________________

15.7 BUDGETARY CONTROL

Planning and control are closely linked. Where planning looks ahead to determine what course of
action to take to achieve objectives, control looks back to compare the planned outcomes with
outcomes achieved, i.e., to see if what happened was what was planned to happen. Effective control
requires that steps are taken so that actual outcomes are in line with the planned outcomes. To ensure
effective budgetary control, budgets must be effectively monitored and managed.

Monitoring the budget means to first check the accuracy of the actual income and expenditure reported
(the actual outcomes). If the reported actual outcomes are accurate, they are compared with the
budgeted outcomes. Any differences (variances) are calculated: how much is the difference? is the
budget more or is actual income/spending more? etc. The next step is to identify the reasons for and
possible trends of the variances and then to discuss them with the budget owner. Identifying the
reasons for the variances is essential for effective budgetary control, as the budget owner must know
what appropriate corrective action to take. Variances can be positive or negative, reflecting over-
spending or under-spending, or over -or under-performance on income.

There could be any number of reasons for budget variances, for example:
• errors in the accounting system, e.g., the incorrect budget was charged with an expense.
• timing differences, e.g., some sales have taken place as budgeted but have not yet been recorded
in the accounting system.
• unrealistic budgeting.
• unplanned events, e.g., changes in legislation.

Only significant variances are investigated to determine what caused them; the causes can be either
replicated (where variances are favourable) or eliminated (where variances are unfavourable). Trivial
discrepancies are ignored. A variance of R100 for rent paid is probably not worth the cost and effort to
investigate the reason thereof. Similarly, a variance 0,1% of budgeted spending could be caused by
any number of random factors, but a variance of 10% may signal a problem that needs to be
addressed.

Managing the budget means taking the required action, based on the results of monitoring, to ensure
the budget remains within control. Budgets are controlled effectively only if corrective action is taken
in response to the reported variances. Sometimes the explanation for the variance results in no action
being required, e.g., a timing difference, as this difference will be eliminated over time. Variances that
are the result of fundamental changes, e.g., new legislation, will require action to regain control over
the budget. Corrective action may include:
• reducing controllable expenses.
• transferring the budget from one line item to another, e.g., transferring a portion of the travelling
budget to the staff training budget.

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• redefining the objectives for the year.

The action could be to either take corrective action so that actual outcomes can still be achieved as
planned (as e.g., the second bullet above indicates), or, if it has become impossible to attain planned
outcomes, modify the plan (as e.g., indicated by the third bullet above). Budgetary management and
control are a continuous process to ensure that any deviation from planned outcomes can be identified
as early as possible so that the best corrective action can be taken.

In comparing planned spending with actual spending, it is important to distinguish between controllable
costs and uncontrollable costs. The manager of a responsibility centre cannot control all costs that are
allocated to the responsibility centre. Controllable costs are those costs that the manager can influence
and be held accountable for. An example of such a cost is the usage of raw materials; the production
manager or shift supervisors are responsible for ensuring that the correct type and quantity of material
is used efficiently during the production process. Uncontrollable costs are costs that the manager
cannot control directly. Examples of such costs are depreciation of equipment and cost of abnormal
idle time due to load shedding. These costs should be excluded from a manager’s performance report,
simply because managers cannot be held responsible for costs and events that they cannot control.

Some of the advantages of effective budget monitoring and control are that:
• objectives and action plans are clearly stated.
• it ensures co-ordination between different responsibility centres.
• it assists in pinpointing responsibility.
• it facilitates timely problem solving.

ACTIVITY 15.4

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 The static budget is one that is geared to one level of output.
1.2 Budget reports compare actual results with planned objectives.
1.3 Budget reports comparing actual results with planned objectives should be prepared only once
a year.
1.4 If actual results are different from planned results, the difference must always be investigated by
management to achieve effective budgetary control.
1.5 Certain budget reports will be prepared monthly whereas others will be prepared more
frequently, depending on the activities being monitored.

15.8 FLEXIBLE BUDGETS

The period since late 2019 is one that will not easily be forgotten. It was a time of repeated lock-downs,
curfews, work-from-home orders, travel restrictions, a ban on the sale of certain substances, all with
unprecedented effects on individuals and businesses. We saw severe shortages of products, border
closures, and more. These were the effects of the Covid pandemic. Many people lost loved ones and
for many businesses their business environment had changed markedly, even permanently. The effect
on strategic planning of major events like a pandemic is enormous. Organisations that do not plan for
different possible scenarios may fail. A business-as-usual attitude to budgeting, with its traditional
inputs and approaches, is no longer fit for this purpose. Companies will have to rethink, for example,
their sources of revenue and how have they changed during the pandemic, for example, a move to
on-line shopping as opposed to in-store shopping. Another question to ask would be if sales are
concentrated around a group of customers and, if so, what will happen in the event of a drastic shift or
decline within this group? What would be the effect on the core business of the company, e.g., liquor
stores? Companies should consider flexible budgeting instead of the traditional, static budgeting
process.

A flexible budget is a budget that flexes (adjusts) with changes in sales volumes; in other words, it is
based on different volumes of sales. A static budget is developed for a single level of output. A flexible

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budget is therefore more practical than a static budget in an uncertain business environment. Even
without the uncertainty brought about by the recent pandemic and other issues, such as climate
change, a flexible budget is preferable to a static budget. This is so because budgets are often linked
to the performance evaluation of the managers of responsibility centres. A flexed budget is a useful
tool for purposes of performance evaluation. For performance evaluation purposes, a budget report is
prepared that shows actual results, budgeted numbers and the variance between the two. A variance
could be favourable or unfavourable. A budget report only shows the variances, it does not explain
them. Managers need to understand the variances so that they can decide whether any action is
needed and, if so, what the action should be. For example, if total sales were higher than budgeted,
was it because more units were sold or because less trade discount was given or because the unit
selling price was higher?

We know that variable costs tend to track the volume of sales while fixed costs remain fixed. If a company
prepares a static budget and then sells more units than budgeted, the variable costs are likely to be
higher than budgeted. Although it is obviously better for the company to have higher sales volumes than
anticipated, a static budget may make the higher variable costs appear as bad for the company and
reflect poorly on the performance evaluation of cost centre managers, especially the production
manager. It should be clear that it would be wrong to compare actual performance with a fixed, unflexed
budget. Fixed budgets will work well only when the budget report is prepared for fixed costs. (The budget
set for XYZ Ceramics in Example 15.2 is a static budget.)

Example 15.4

Pumi drafted the budget below for her Supreme Pies business for June. She based her calculations
on an output level of 5 000 units made and sold (there are no opening or closing inventories). You may
assume that the unit production cost is the standard production cost. Standard costing is discussed in
greater detail in Learning Unit 16.
Unit Total
R R

Sales (5 000 units × R20 each) 20,00 100 000

Less: Variable cost 11,50 57 500
Direct material (7 500 kg × R4,00 per kg) 6,00 30 000
Direct labour (500 hours × R20,00 per hour) 2,00 10 000
Production overheads (500 labour hours × R10,00 per hour) 1,00 5 000
Sales commission (5 000 units × R2,50 per unit) 2,50 12 500
Contribution 8,50 42 500
Less: Fixed cost 27 500
Production 20 000
Sales and administration 7 500
Budgeted net profit 15 000

The following were the actual results of Pumi’s Supreme Pies for June:
R

Sales (6 000 units × R22,50 each) 135 000

Less: Variable cost 70 365
Direct material (8 400 × R3,90 per kg) 32 760
Direct labour (630 hours × R22,50 per hour) 14 175
Production overheads 6 930
Sales commission (6 000 units × R2,75 per unit) 16 500
Contribution 64 635
Less: Fixed costs 27 800

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Manufacturing 20 500
Sales and administrative 7 300
Actual net profit 36 835

The variance of R21 835 (R36 835 – R15 000) in net profit may have arisen due to the following reasons:
• Variances in production/sales volume
• Variances in cost and/or efficiency

The variances that arose due of the increased number of units manufactured and sold (6 000 – 5 000
= 1 000) are output volume variances. The variances that arose due to cost or efficiencies differences
are price/cost and quantity/efficiency variances.

A budget report, comparing actual results with the static budget, would not be useful, except to state
the overall variance, i.e., R21 835 (R36 835 – R15 000). The first step in preparing a budget report
would be to prepare a flexed budget, which is nothing more than a restatement of the original, static
budget as if 6 000 units were planned for in the first place. In other words, the flexed budget will be
prepared for 6 000 units, using the same standard production costs as the original, static budget used
for 5 000 units. After the flexed budget has been prepared:
• The flexed budget is compared to the static budget to determine what variances arose as a result
of difference in output, i.e., the variances because 6 000 instead of 5 000 units were made and
sold.
• The flexed budget is compared to the actual performance to determine the cost/efficiency
variances.

Original (static) budget Flexed budget Actual results

variance in output volume cost/efficiency variances

The difference between the profit of the static budget and the profit of the flexed budget that result
from the output variance should be equal to 6 000 – 5 000 = 1 000 units × R8,50 contribution per unit,
i.e., R8 500. Let us see if this is true. A comparison of the flexed budget and static budget for Supreme
Pies appears below (notice that the only difference between the two budgets is the number of sales
units on which the budgets are based; unit costs/prices remain the same):

Flexed Static Variance

Output volume variance: units → 6 000 5 000 1 000
R R R

Sales (6 000 units @ R20,00) 120 000 100 000 20 000 (f)
Less: Variable cost 69 000 57 500 11 500(u)
Direct material
[(7 500 kg / 5 000 × 6 000) @ R4 per kg] 36 000 30 000 6 000(u)
Direct labour
[(500 hours / 5 000 × 6 000) @ R20,00 per hour] 12 000 10 000 2 000(u)
Production overheads 6 000 5 000 1 000(u)
[(500 hours / 5 000 × 6 000) @ R10,00 per hour]
Sales commission
(6 000 units @ R2,50 per unit) 15 000 12 500 2 500(u)
Contribution 51 000 42 500 8 500 (f)
Less: Fixed cost 27 500 27 500
Production 20 000 20 000
Sales and administration 7 500 7 500

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Net profit 23 500 15 000 8 500 (f)

The difference between the profit of the static budget and the profit of the flexed budget is R8 500
favourable, and that is that same as the difference in volume × contribution per unit, i.e.:1 000 units ×
R8,50 = R8 500.

In this example, the output volume variance (flexed budget – static budget) is R8 500 favourable and
the cost/efficiency variances (flexed – actual) will be R13 335 favourable (the overall favourable
variance of R21 835 minus the favourable volume variance of R8 500):

Cost/efficiency variances Flexed Actual

budget results Difference
Volume in units → 6 000 6 000
R R R
Sales (6 000 × R20,00); (6 000 × R22,50) 120 000 135 000 15 000 (f)
Less: Variable cost 69 000 70 365 1 365(u)
Direct material
(above); (8 400 kg × R3,90 per kg) 36 000 32 760 3 240 (f)
Direct labour
(above); (630 hours × R22,50 per hour) 12 000 14 175 2 175(u)
Production overheads
(above); (given) 6 000 6 930 930(u)
Sales commission
(above); (6 000 units × R2,75 per unit) 15 000 16 500 1 500(u)
Contribution 51 000 64 635 13 635 (f)
Less: Fixed cost 27 500 27 800 300(u)
Production 20 000 20 500 500(u)
Sales and administration 7 500 7 300 200 (f)
Net profit 23 500 36 835 13 335 (f)

There is a total favourable selling price variance of R15 000 and a total unfavourable cost/efficiency
variance of R1 665 (1 365 + 300), thus an overall favourable variance of R13 335. Note: the selling
price variance is calculated by multiplying the difference between the budgeted unit selling price and
the actual unit selling price by the actual number of units sold, i.e., (R22,50 – R20) × 6 000 = R15 000.

Let us take a closer look at the material variance:

The (flexed) budget to produce 6 000 units is : 9 000 kg × R4,00 = R36 000
Actual cost to produce 6 000 units was : 8 400 kg × R3,90 = R32 760
resulting in a favourable variance of : R3 240
Difference 600 kg R0,10
The price variance is R0,10 × 8 400 kg = R840 favourable
The quantity of materials quantity variance is 600kg × R4 = R2 400 favourable
R3 240 favourable
Let us take a closer look at the labour variance:
The (flexed) budget to produce 6 000 units is : 600 h × R20,00 = R12 000
Actual cost to produce 6 000 units was : 630 h × R22,50 = R14 175
resulting in a favourable variance of : ( R2 175)
Difference (30)h (R2,50)
The labour rate variance is R2,50 × 630 h = (R1 575) unfavourable

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The labour efficiency variance is 30h × R20 = (R600) unfavourable

(R2 175) unfavourable

Let us take a closer look at the variable production cost:

The (flexed) budget to produce 6 000 units is : 600 h × R10,00 = R6 000
Actual cost to produce 6 000 units was * : 630 h × R11,00 = R6 930
resulting in a favourable variance of : ( R930)
(30)h (R1,00)
The overhead rate variance is R1,00 × 630 h = (R630) unfavourable
The overhead efficiency variance is 30h × R10 = (R300) unfavourable
(R930) unfavourable

* Variable overheads are allocated based on labour hours

R6 930 would be based on 630 labour hours:
R6 930 / 630 = R11 per labour hour

Let us take a closer look at the sales commission:

The (flexed) budget to produce 6 000 units is : 6 000 × R2,50 = R15 000
Actual cost to produce 6 000 units was * : 6 000 × R2,75 = R16 500
resulting in a favourable variance of : ( R1 500)
(R0,25)
The commission expense variance is R0,25 × 6 000 u = (R1 500) unfavourable

Summary of variances: R
Output volume variance 8 500 F
Sales price variance 15 000 F
Material purchase price variance 840 F
Material quantity variance 2 400 F
Labour rate variance (1 575) U
Labour efficiency variance (600) U
Variable overhead rate variance (630) U
Variable overhead efficiency variance (300) U
Sales commission expense variance (1 500) U
Total fixed production cost variance (R20 500 – R20 000) (500) U
Total fixed sales and admin costs (R7 300 – R7 500) 200 F
Total variance between the (static) budget and actual results 21 835 F

Pumi will investigate the variances that she deems significant to find the reasons for the variances.
For example, does a favourable materials price variance perhaps indicate that inferior ingredients were
used which may impact on the quality of the product? Could the favourable materials quantity variance
perhaps indicate that the standard quantity was set too generously? We shall take a closer look at
standards and variances in the next learning unit.
________________________________________________________________________________

If a flexible budget for different levels of sales under different scenarios is prepared in the planning
stage, it allows management to consider budgeted numbers for the different scenarios under
consideration and then to take a decision about the most likely outcome for the company.

In the strict sense of the word, there is a difference between a flexible budget and a flexed budget. A
flexible budget is prepared at the beginning of the budgeting period (for planning purposes) and a
flexed budget is created during and at the end of the budget period (for control purposes).

The comparison of actual results with budgeted numbers and the investigation and corrective action
that follow is the concept underlying management by exception. Significant variances are investigated

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to determine what caused them; the causes can be either replicated (where variances are favourable)
or eliminated (where variances are unfavourable). Trivial discrepancies are ignored.

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ACTIVITY 15.5

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 A flexible budget can be prepared for each of the operational budgets included in the master
budget.
1.2 Flexible budgeting relies on the assumption that variable unit costs will remain constant within
the relevant range of output.
1.3 Total budgeted fixed costs appearing on a flexible budget will be the same amount as total fixed
costs on the master budget.
1.4 To determine variances based on volume, actual results are compared to flexed budgeted
results.

QUESTION 2

For each of the following questions, read carefully through the information provided and select only
the most correct option as your answer.
2.1 A company's budgeted level of output was 1 130 units manufactured and sold. Actual level of
output was 1 180 units manufactured and sold. Variable overhead cost is budgeted at R2,60 per
unit. Actual variable overhead cost was R2 130. In the company's flexed budget performance
report the cost variance would be …
(a) R808 F.
(b) R938 F.
(c) R90 U.
(d) R130 U.
2.2 Budgeted sales are: March: 12 000 units, April: 13 000 units, May: 15 000 units and June: 19 000
units. Closing finished goods inventory policy is 10% of the following month's sales. Inventory
on 1 March is 1 500 units. Production for March will be … units.
(a) 11 800
(b) 12 200
(c) 13 000
(d) 14 800

QUESTION 3

Acu Darts Ltd buys and sells dartboards. The manager prepared the following budgeted contribution
statement of comprehensive income for March:

R
Sales 1 200 000
Variable costs 1 075 000
Opening inventory 100 000
Purchases 1 075 000
Closing inventory (175 000)
Variable selling expenses 75 000
Contribution 125 000
Fixed costs 145 000
Warehouse overheads 100 000
Marketing and administration 45 000
Net loss before tax (20 000)

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Additional information
• The opening balance on the bank opening is R120 000.
• 70% of total sales and 60% of inventory purchases are on a cash basis. These percentages vary
from month to month, depending on available cash and discounts on offer.
• The selling price per dartboard is R120.
• All other expenses are incurred on a cash basis.
• Acu Darts Ltd wants to have closing inventory of 17,5% of the units sold during the month.
• Cash payments in March to settle February credit purchases will amount to R312 000.
• Cash receipts in March in respect of credit sales in February will amount to R390 000.
• The variable cost per unit as budgeted for March is the same as in February.
• Total depreciation amounts to R12 000 per month.
REQUIRED
3.1 Calculate the budgeted number of units in: opening inventory, purchases, sales and closing
inventory.
3.2 Calculate the total variable cost per unit.
3.3 Prepare a cash budget for March and calculate the estimated closing balance in the bank
account.

QUESTION 4

Lexis Ltd is in the process of finalising its budget. Various production levels are still being considered.
Lexis Ltd uses various techniques to determine the fixed and variable components of individual cost
items in the budget for production department Z (a cost centre). Machine hours are used as the basis
for allocating overheads. The historical capacity utilisation varied from 8 000 to 12 000 direct machine
hours per month. The average long run capacity utilisation is 10 000 machine hours per month. An
analysis showed the following for the budget year:
The annual salaries of supervisors amounted to R48 000 in the previous year and management is now
contemplating a 5% increase for the budget year.
Property assessment rates are estimated at R2 850 for the year.
An analysis of the monthly cost data according to the least squares method for the previous nine
months produced the following results (the fixed component is per month and the variable rate is
indicated per machine hour):
Depreciation: y = R1 440 + R0x
Materials handling: y = R240 + R0,6x
Management reviewed these results and decided to raise material handling costs by an overall 10%.
Water and electricity for this department is estimated at R1 200 at a monthly production volume of
12 000 machine hours. Industrial engineers agree that the cost at this level should be 20% fixed and
80% variable.
Indirect wages (semi-variable) are estimated as follows:
9 600 machine hours: R4 500
12 000 machine hours: R5 250
Maintenance (variable) is estimated as follows:
At maximum output of 12 000 hours: R6 250
At minimum output of 9 600 hours: R5 000
The least squares method of analysis indicates that the other semi-variable overheads would be as
follows (on a monthly basis):
Fixed R400
Variable R0,50 per machine hour
but a general price reduction of 10% is expected.
REQUIRED

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4.1 Use the information above to draft the monthly overhead cost budget for production department
Z for the first quarter, based on production volumes of 9 000, 9 500 and 10 000 machine hours
per month respectively.
4.2 Determine the total budgeted overhead allocation to the work-in-process account for each
month.
4.3 Calculate the over or under recovery of budgeted fixed overheads. Where required, work to five
decimals.

QUESTION 5

Refer to the information in QUESTION 4 and assume that the actual overhead costs for Month 2 are
as follows:
Supervisors’ salaries: R4 160 after successful negotiation for a 4% increase.
Property assessment: R240.
The monthly cost data produced the following results, where x is direct machine hours):
Depreciation: y = R1 440 + R0x
Materials handling: y = R245 + R0,65x
Water and electricity cost was R970. The fixed component was as per budget.
Indirect wages were R4 800, of which 65% was variable.
Maintenance cost (variable) was R5 400.
Of the other semi-variable overheads, R360 was fixed with a variable portion of R0,48 per machine hour.
Actual machine hours for the month were 9 800 hours.
REQUIRED
a. Flex the budget for Month 2 and determine whether there were any favourable or unfavourable
variances.
b. Determine the over or under- recovery of fixed overheads for Month 2.

15.9 SUMMARY

In this learning unit, we explained the purpose of budgeting and how it fits into the overall planning and
control framework of the company. The long-term plan is the outcome of strategic planning and it set
out the preliminary targets that must be achieved to reach the strategic goals. The annual budget sets
out the detailed financial plan for the achievement of the planned objectives for the year. We have
identified that the objectives of budgeting and the budget are to assist in the planning of the operational
activities for the year (paragraph 15.1).

In paragraph 15.2, we explained responsibility centres, the stages in the budgeting process and
administration of the process. We looked at the different approaches to budgeting (incremental, ZBB
and ABB) and the advantages and disadvantages of each. We then explained static, flexible and rolling
budgets.

In paragraph 15.3 we explained operational budgets, in paragraph 15.4 we explained financial budgets
and in paragraph 15.5 we briefly described the master budget. We then illustrated the preparation of
operational and cash budgets by means of comprehensive examples. We demonstrated how the
operational budgets culminate in the preparation of the budgeted statement of comprehensive income.

In paragraphs 15.7 and 15.8 we described budgetary control and the need for flexing the budget for
determining how actual performance deviate from budgeted performance.

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