C h a p t e r INDUSTRIAL BUDGETING AND COST ANALYSIS 10.1 INTRODUCTION Everybody is familiar with the idea of a plan. Not only in business, but in private life also people make plans though there are considerable differences in the way in which they plan. Some people do their planning entirely in their hands; others do it on rough papers and still other formally express their plans in quantitative terms. The process involved in the later group is called Budgeting. A budget is a plan relating to a period of time in quantitative terms. The characters of budget are: (i) A budget may be expressed in terms of quantity or money or both. (ii) A budget is prepared for definite future period. (iii) The purpose of budget is to implement the policies formulated by the management for attaining the given policies. 10.1.1 OBJECTIVE OF BUDGET Generally, the budget is used in financial planning and control. Hence, these types of control are often called as Budgetary Control. The objective of budget or budgetary control may be expressed under three heads. (a) Planning (b) Co-ordination (c) Control (a) Planning: A budget provides a detailed plan of action for a business order for a definite period of time. Detailed plan relating to production, sales, raw material requirement, labor needs, advertising and sales promotion, R & D activities, capital additions etc. are drawn up. By planning many problems are anticipated long before they arise and the solutions can be sought through careful study. Thus in most business emergencies or rush up conditions can be avoided by planning. In brief, budget forces management to think ahead and to anticipate and prepare for the anticipated conditions. (b) Co-ordinations Budgeting aids managers in coordinating their efforts so that objectives of the organization as a whole are harmonized with the objectives of its parts. Effective planning and organization contributes a lot in achieving co-ordinations. There should be the co-ordination in the budgets of various departments. For example-a budget of sales should be in coordination with the budget of production. Similarly, production budget should be prepared in coordination with purchase budget and so on. (c) Control Control is necessary to ensure that plans and objectives as laid down in budgets are being achieved. Control, as applied to budgeting is a systematic effort to keep management information of whether planned performance is being achieved or not. For this purpose, a comparison is made between plans and actual
A Text Book of Operational Research and Food Plant Management performance. The difference between the two is reported to management for taking corrective action. This control is not possible without planning. 10.1.2 ADVANTAGES OF BUDGETARY CONTROL Budgetary control provides the following advantages: (1) Budget compels management to think ahead to anticipate and prepare for changing conditions. (2) Budgeting co-ordinates the activities of various departments and function of the business. (3) It increases the production efficiency, eliminates waste and control of cost. (4) It pin points efficiency and/or lack of it. (5) It aims at maximization of profit through careful planning and control. (6) It provides the yardstick against which actual results can be compared. (7) It ensures that the working capital is available for the efficient operation of the business. (8) It directs capital expenditure in the most profitable directions. (9) A budget motivates executives to attain the given goals. (10) Budgetary control system creates necessary conditions for the introduction of standard costing techniques. (11) Budgetary also aids in acquiring capital from the external source. (12) It assists in delegation of authority and assignment of the responsibility. (13) Budget creates cost consciousness and introduces an attitude of mind in which waste and efficiency cannot thrive. 10.1.3 LIMITATIONS OF BUDGETARY CONTROL SYSTEM The list of advantages given above is impressive, but a budget is not a cure of all organizational ills. Budgetary control system suffers from certain limitations and those using the system should be fully aware of them. (a) The budget plan is based on estimates Budgets are based on forecasts and forecasting cannot be an exact science. Absolute accuracy therefore is not possible in forecasting and budgeting. The strength and weakness of budgetary control system depends to a large extent, on the accuracy with which estimates are made. Thus, while using the system, the fact that budget is based on estimates must be kept in view. (b) Danger of rigidity A budget program must be dynamic and continuously deal with the changing business conditions. Budgets will lose much of their usefulness if they acquire rigidity and are not revised with the changing circumstances. (c) Budget is only a tool of management Budget cannot take the place of management but only a tool of management. The budget should not be regarded as a master but as a servant Sometime it is believed that introduction of budget performance is alone sufficient to ensure its success. Executive of a budget will not occur automatically. It is necessary that the entire organization must participate enthusiastically in the program for the realization of budgetary goals. (d) Expensive technique The installation and operation of a budgetary control system is costly affairs as it require the employment of specialized staff and involves other expenditure so that small concerns may find it difficult to adopt it. However, it is essential that the cost of introducing and operating a budgetary control system should not exceed the benefits derived there from. 10.1.4 ESSENTIALS OF EFFECTIVE BUDGETING A budgetary control system can prove successful only when certain conditions and attitudes exist. e.g. (a) Support to and from top management (b) Participation by responsible executives (c) Reasonable goals (d) Clearly defined organization structure (e) Continuous budget education 148
Industrial Budgeting and Cost Analysis (f) Adequate auditing and accounting system (g) Maximum profit (aim/target) (h) Cost of the system (cost effective, worth > cost) 10.2 TYPES OF BUDGET Budgets are classified as many ways. A simple classification is shown below: Budget - Fixed Budget Functional Budget - Variable Budget - sales budget - Zero based budgeting - Production (cost) budget - RM budget - Purchase budget - Labor budget - Production overhead budget - Selling & distribution cost budget - Administration cost budget - Capital expenditure budget - Cash budget Master Budget (a) Sales Budget In most companies, the sales budget is not only the most important but also the most difficult budget to prepare. The important of this budget arise from the fact that if sales figure is not correct, then practically all other budget will be affected. The difficulties in the preparation of this budget arise because it is not easy to estimate consumer s demand, particularly when new product is introduced. The sales budget is a statement of planned sales in terms of quantity and value. It forecast what the company could reasonably expect to sell to its customers during the budget period. Past sales, reports by salesman, company conditions, business conditions, and market analysis are some parameters affecting the sales budget. Solved example 1: Susan s shop sell two product Geeta and Som in four areas- North, South, East and West. The following sales are budgeted for the month of January 2005. North: Geeta 6000 units & Som 3250 units South: Som 6500 units East: Geeta 8500 units West: Geeta 4500 units & Som 2750 units Selling price: Geeta Rs.30/unit & Som Rs.15/ unit It was decided that the additional advertising campaign would be undertaken in South & East, which will result in additional sales of 1500 units of Geeta in South and 2500 units of Som in East.You are required to prepare the sales budget for the month of January 2005. Sales budget for January 2005 Area Product Quantity (units) Price Amounts North Geeta 6000 30 180000 Som 3250 15 48750 9250 228750 South Geeta 1500 30 45000 Som 6500 15 97500 8000 142500 East Geeta 8500 30 255000 Som 2500 15 37500 11000 292500 West Geeta 4500 30 135000 Som 2750 15 41250 7250 176250 North Geeta 20500 30 615000 Som 15000 15 225000 Total 35500 840000 149
A Text Book of Operational Research and Food Plant Management (b) Production Budget: The production budget is an estimate of production for the budget period. It is first drawn up in quantities of each product and when the remaining budget have been compiled and cost of production calculated, then the quantities of production cost are translated into money terms, what in effect becomes a production cost budget. The production budget is the initial step in budgeting manufacturing operation. There are at least three principal budgets related to manufacturing in addition to production budget. These are raw material budget, labor budget and production overhead budget. The principal considerations involved in budgeting production are: Sales budget Inventory policy Production capacity Management policy Solved example 2: Dharan Agro Chemicals manufactures chemical X. A forecast for the quantity sold in the first four month of the year 2005 is as follows: January 6000 units February 6000 units March 5200 units April 4400 units It is anticipated that : (a) There will be no WIP at the end of any month. (b) Finished units equal to half the sales for the next month will be in stock at the end of each month including December 2003. You are required to prepare a production budget for each of the three months ending 31 st March 2004. Solution Production Budget (For the three months ending 31 st March 2004) Particulars January (units) February (units) March(units) Budgeted sales Add closing stock Less opening stock Production 6000 3000 9000 3000 6000 6000 2600 8600 3000 5600 5200 2200 7400 2600 4800 (c) Raw material budget: This budget shows the estimated quantities of all the raw materials and components needed for the output demanded by the production budget. Raw material budget serves the following purposes It assists purchasing departments in planning the purchases. It helps in the preparation of purchase budget. It provides data for RM control. It should be noted that RM budget generally deals with only the direct materials, indirect materials and supplies are generally including in overhead cost budgets. (d) Purchase budget Careful planning of purchase offers one of the most significant areas of cost saving in many concerns. The purchase manager should be assigned the direct responsibility for preparing the detailed plan of purchase for the budget period and for submitting the plan in the form of a purchase budget The purchase budget provides details of the purchases, which are planned to be made during the period to meet the needs of the business. The purchase budget indicates The quantities of each type of RM and other items to be purchased. The timing of purchase. The estimated cost of material purchases. The factors to be considered in preparing purchase budget are: 150
Industrial Budgeting and Cost Analysis Opening and closing stock to be maintained Maximum and minimum stock quantities. EOQ Financial resource available Material management policies (e) Labor budget Labor is classified into direct and indirect. Some concern prepare labor budget that includes both direct and indirect labor, while other include only direct labor cost and include indirect labor in overhead cost budget. The labor budget represents the forecast of labor requirement to meet the demand of the company during the budget period. This budget must be linked with production budget and production cost budget. The labor budget serves the following purposes To estimate the labor cost of production To determine the direct labor required in terms of labor hours and hence the number and grade of workers required to meet the production requirements. To provide the personnel departments with personnel requirements so that it may plan recruitment activities To provide data for managerial control of labor cost (e) Other budgets Production overhead budget Selling and distribution cost budget Administration cost budget Capital expenditure budget Cash budget (f) Master Budget: When all the subsidiary budgets have been prepared, these are summarized into what is called Master budget. The master budget shows the overall plan of the business for the next period. It is commonly prepared in the form of a forecasted profit and loss account and balance sheet and is variously called summary budget, planning budget or operating plan.the master budget is prepared by the budget director or officer and is presented to the budget committee for approval. If approved, it is submitted to the Board of Directors for final approval. The board may make certain amendments/alterations before it is finally approved. A master budget may be prepared in following form (data assumed) Master budget for the year ending 31 December 2005 Budget period Previous period A) Net sales Rs.7, 00,000 %100 Rs.655000 %100 Less production cost Direct material 250000 35.71 235000 35.88 Direct labor 90000 12.85 98000 14.96 Production overhead 70000 10.00 81000 12.37 B) Total production cost 410000 58.56 414000 63.21 C) Gross profit (A-B) 290000 41.44 241000 36.79 Less operating expense Administration exp. 16000 2.29 17000 2.60 Selling & distribution exp. 35000 5.00 38000 5.80 R&D exp. 12000 1.71 10000 1.53 Financial exp. 9000 1.29 9000 1.37 D) Total operating exp. 72000 10.29 74000 11.30 Operating profit (C-D) 218000 31.14 167000 25.49 Add other incomes 8500 1.21 8000 1.22 Net profit 226500 32.35 175000 26.71 Assets Fixed 465000 63.70 492500 68.88 Current 265000 36.30 222500 31.12 Total capital employed 730000 100 715000 100 151
A Text Book of Operational Research and Food Plant Management 10.3 FIXED AND VARIABLE BUDGET Fixed Budgets: Fixed budget is one, which is prepared keeping in mind one level of output. It is defined as one which is designed to remain unchanged, irrespective of the level of activity attained. If the actual output differs from budgeted level of output, variances will arise. Fixed budget is prepared on the assumption that output and sales can be estimated with a fair degree of accuracy. This means that in those situations where sales and outputs cannot be accurately estimated, fixed budget doesn t suit. Flexible Budget In contrast to fixed budget, a flexible budget is one which is designed to change in relation to the level of activity attained. The underlying principle of flexible budget is that a budget is of little unless cost and revenue are related to the actual volume of production. Flexible budgeting has been developed with the objectives of changing the budget figures to correspond with the actual output achieved. Thus a budget might be prepared for various levels of actual output achieved. Thus a budget might be prepared for various levels of activity say 70%, 80%, 90% and 100% capacity utilization. Then whatever the level of output actually reached, it can be compared with appropriate level. Flexible budgets are prepared in those companies where it is extremely difficult to forecast output sales. 10.4 ZERO BASED BUDGETING (ZBB) Zero- based budgeting was introduced at Texas instruments in USA in 1969. It is a modern management tool for planning and controlling expenditure. However, ZBB is not conceptually new because every company might have experienced this approach once in its lifetime e.g. when the company had prepared its first budget or when a reorganization of a company calls for a budget revision. Traditionally, most firms prepare their budget on the basis of their previous year s budget, perhaps with some adjustment for price level changes. Additional items requested are scrutinized, but the portion of a budget request representing a continuation of the previous year s level of activity is not generally challenged. As a result, many organizations found that wasteful and unnecessary activities were being continued year after year simply because no body was ever asked to explain their need. ZBB attempts to correct this problem. ZBB requires every item of the budget to be justified every year. Under ZBB, there is a continuous reevaluation of the activities of the organization to ascertain that activities are absolutely necessary for the organization. Those of the activities, which are of no value, find no place in the forth-coming budget even though these might have been an integral part of the past budget prepared under traditional approach. ZBB in a way tries to locate those activities, which are not essential. 152