Budgeting and Cost Control
Topic 7
McGraw-Hill/Irwin
Learning Objective 1
Understand why
organizations budget and
the processes they use to
create budgets.
9-2
The Basic Framework of Budgeting
A budget is a detailed quantitative plan for
acquiring and using financial and other resources
over a specified forthcoming time period.
1. The act of preparing a budget is called
budgeting.
2. The use of budgets to control an
organization’s activities is known
as budgetary control.
9-3
Planning and Control
Planning – Control –
involves developing involves the steps taken by
objectives and management to increase
preparing various the likelihood that the
budgets to achieve objectives set down while
those objectives. planning are attained and
that all parts of the
organization are working
together toward that goal.
9-4
Advantages of Budgeting
Define goals
and objectives
Communicate Think about and
plans plan for the future
Advantages
Coordinate Means of allocating
activities resources
Uncover potential
bottlenecks
9-5
Responsibility Accounting
Managers should be held
responsible for those
items - and only those
items - that they can
actually control
to a significant extent.
9-6
Choosing the Budget Period
Operating Budget
2008 2009 2010 2011
Operating budgets ordinarily
A continuous budget is a
cover a one-year period
12-month budget that rolls
corresponding to a company’s
forward one month (or quarter)
fiscal year. Many companies
as the current month (or quarter)
divide their annual budget
is completed.
into four quarters.
9-7
Self-Imposed Budget
Top Management
Middle Middle
Management Management
Supervisor Supervisor Supervisor Supervisor
A self-imposed budget or participative budget is a budget that is
prepared with the full cooperation and participation of managers
at all levels.
9-8
Advantages of Self-Imposed Budgets
1. Individuals at all levels of the organization are viewed
as members of the team whose judgments are valued
by top management.
2. Budget estimates prepared by front-line managers are
often more accurate than estimates prepared by top
managers.
3. Motivation is generally higher when individuals
participate in setting their own goals than when the
goals are imposed from above.
4. A manager who is not able to meet a budget imposed
from above can claim that it was unrealistic. Self-
imposed budgets eliminate this excuse.
9-9
Self-Imposed Budgets
Self-imposed budgets should be reviewed
by higher levels of management to
prevent “budgetary slack.”
Most companies issue broad guidelines in
terms of overall profits or sales. Lower
level managers are directed to prepare
budgets that meet those targets.
9-10
Human Factors in Budgeting
The success of a budget program depends on three
important factors:
[Link] management must be enthusiastic and
committed to the budget process.
[Link] management must not use the budget to
pressure employees or blame them when
something goes wrong.
[Link] achievable budget targets are usually
preferred when managers are rewarded based on
meeting budget targets.
9-11
The Budget Committee
A standing committee responsible for
❖ overall policy matters relating to the budget
❖ coordinating the preparation of the budget
❖ resolving disputes related to the budget
❖ approving the final budget
9-12
The Master Budget: An Overview
Sales budget
Selling and
Ending inventory administrative
Production budget
budget budget
Direct materials Direct labor Manufacturing
budget budget overhead budget
Cash Budget
Budgeted
Budgeted
income
balance sheet
statement
9-13
Format of the Cash Budget
The cash budget is divided into four sections:
1. Cash receipts section lists all cash inflows excluding cash
received from financing;
2. Cash disbursements section consists of all cash payments
excluding repayments of principal and interest;
3. Cash excess or deficiency section determines if the
company will need to borrow money or if it will be able to
repay funds previously borrowed; and
4. Financing section details the borrowings and repayments
projected to take place during the budget period.
9-14
Characteristics of Flexible Budgets
May be prepared for any activity
level in the relevant range.
Show costs that should have been
incurred at the actual level of
activity, enabling “apples to apples”
cost comparisons.
Help managers control costs.
Improve performance evaluation.
Let’s look at Larry’s Lawn Service.
10-15
Deficiencies of the Static Planning Budget
Larry’s Lawn Service provides lawn care in a planned
community where all lawns are approximately the same size.
At the end of May, Larry prepared his June budget based on
mowing 500 lawns. Since all of the lawns are similar in size,
Larry felt that the number of lawns mowed in a month would
be the best way to measure overall activity for his business.
Larry’s Budget
10-16
Deficiencies of the Static Planning Budget
Larry’s Planning Budget
10-17
Deficiencies of the Static Planning Budget
Larry’s Actual Results
10-18
Deficiencies of the Static Planning Budget
Larry’s Actual Results Compared with the Planning Budget
10-19
Deficiencies of the Static Planning Budget
Larry’s Actual Results Compared with the Planning Budget
Since these variances are unfavorable, has
Larry done a poor job controlling costs?
Since these variances are favorable, has
Larry done a good job controlling costs?
10-20
Deficiencies of the Static Planning Budget
▪ The relevant question is . . .
“How much of the cost variances is due to higher
activity, and how much is due to cost control?”
▪ To answer the question,
we must
the budget to the
actual level of activity.
10-21
How a Flexible Budget Works
To a budget we need to know that:
Total variable costs change
in direct proportion to
changes in activity.
Total fixed costs remain
unchanged within the
relevant range. Fixed
10-22
Preparing a Flexible Budget
Larry’s Flexible Budget
10-23
Activity Variances
Planning Flexible
budget revenues budget revenues
and expenses and expenses
The differences between
the budget amounts are
called activity variances.
10-24
Activity Variances
Larry’s Flexible Budget Compared with the Planning Budget
10-25
Revenue and Spending Variances
Flexible budget revenue Actual revenue
The difference is a revenue variance.
Flexible budget cost Actual cost
The difference is a spending variance.
10-26
Revenue and Spending Variances
Larry’s Flexible Budget Compared with the Actual Results
$1,750 favorable
revenue variance
10-27
Revenue and Spending Variances
Larry’s Flexible Budget Compared with the Actual Results
Spending
variances
10-28
Flexible Budgets with Multiple Cost Drivers
More than one cost
driver may be needed to
adequately explain all of
the costs in an organization.
The cost formulas used
to prepare a flexible
budget can be adjusted
to recognize multiple
cost drivers.
10-29
Flexible Budgets with Multiple Cost Drivers
Because of the large unfavorable wages and salaries spending
variance, Larry decided to add an additional cost driver for
wages and salaries. The variance is due primarily to the number
of hours required for the additional edging and trimming. So
Larry estimates the additional hours and builds those hours into
both his revenue and expense budget formulas.
Larry’s New Budget
10-30
Flexible Budgets with Multiple Cost Drivers
Larry’s Budget Based on More than One Cost Driver
10-31
Some Common Errors
The most common errors in preparing performance
reports are to implicitly assume that:
1. All costs are fixed or that
2. All costs are variable.
Assume all costs are fixed.
10-32
Common Error 1: Assuming All Costs Are
Fixed
Faulty Analysis Comparing Budgeted Amounts to Actual Amounts
10-33
Common Error 2: Assuming All Costs Are
Variable
Faulty Analysis that Assumes All budget Items Are Variable
10-34
End of Topic 7
10-35