LO2: Week 4Budget and the role of Budget• A budget is a financial statement or document which indicates theproposed expenditure and expected revenue of the government oran organization• Role of Budget• For planning purposes, budgets can serve as a tool to forecastprofitability, allocate resources or communicate specializedknowledge about one part of an organization to other parts• Management can use operational budgets to motivate persons tohelp achieve the organization’s overall objectives by committingthem to a predetermined plan of actionLO2 Week 4Types of BudgetIncremental budgeting• Incremental budgeting takes last year’s actual figures and adds orsubtracts a percentage to obtain the current year’s budget• However, there are some problems with using the method:• It is likely to perpetuate inefficiencies. For example, if a manager knowsthat there is an opportunity to grow his budget by 10% every year, he willsimply take that opportunity to attain a bigger budget, while not puttingeffort into seeking ways to cut costs or economize• It is likely to result in budgetary slack. For example, a manager mightoverstate the size of the budget that the team actually needs so itappears that the team is always under budget.Activity Based BudgetActivity-based budgeting•Activity-based budgeting is a top down budgeting approachthat determines the amount of inputs required to supportthe targets or outputs set by the company.•For example, a company sets an output target of $100million in revenues.•The company will need to first determine the activities thatneed to be undertaken to meet the sales target, and then•Find out the costs of carrying out these activities.Zero Based Budget• Starts with the assumption that all department budgets are zero and mustbe rebuilt from scratch.• Managers must be able to justify every single expense.• Zero-based budgeting is very tight, aiming to avoid any and allexpenditures that are not considered absolutely essential to thecompany’s successful (profitable) operation.• Zero-based approach is good to use when there is an urgent need for costcontainment,• For example, in a situation where a company is going through a financialrestructuring or a major economic or market downturn that requires it toreduce the budget dramaticallyPreparing Budget• Update budget assumptions. Review the assumptions about the company’sbusiness environment that were used as the basis for the last budget, andupdate as necessary.• Review bottlenecks. Determine the capacity level of the primary challenges thatis constraining the company from generating further sales, and define how thiswill impact any additional company revenue growth.• Available funding. Determine the most likely amount of funding that will beavailable during the budget period, which may limit growth plans.• Step costing points. Determine whether any steps costs will be incurred duringthe likely range of business activity in the upcoming budget period, and definethe amount of these costs and at what activity levels they will be incurred.Preparing Budget Cont.• Issue budget package. Issue the budget package personally, where possible, andanswer any questions from recipients. Also state the due date for the first draftof the budget package.• Obtain revenue forecast. Obtain the revenue forecast from the sales manager,validate it with the CEP, and then distribute it to the other departmentmanagers. They use the revenue information as the basis for developing theirown budgets.• Obtain department budgets. Obtain the budgets from all departments, check forerrors, and compare to the bottleneck, funding, and step costing constraints.Adjust the budgets as necessary.Preparing Budget Cont.• Obtain capital budget requests. Validate all capital budget requests and forwardthem to the senior management team with comments and recommendations.• Update the budget model. Input all budget information into the master budgetmodel.• Review the budget. Meet with the senior management team to review thebudget. Process budget iterations. Track outstanding budget change requests,and update the budget model with new iterations as they arrive.• Issue the budget. Create a bound version of the budget and distribute it to allauthorized recipients.• Load the budget. Load the budget information into the financial software, sothat you can generate budget versus actual reportsQuick CheckClass ActivityClass Group Discussion• Discuss Budget and the various types of Budget• Write in your own words Activity Based Budget and Zero Based BudgetBudget Variance• Budget variance is a periodic measure used by governments, corporations orindividuals to quantify the difference between budgeted and actual figures for aparticular accounting category.• A favorable budget variance refers to positive variances or gains andUnfavorable budget variance describes negative variance, meaning lossesand shortfalls.• Budget variances occur because forecasters are unable to predict the futurecosts and revenue with complete accuracy.• Budget variances can occur from controlled or uncontrollable factors.• For instance, a poorly planned budget and labor costs are controllable factors.Uncontrollable factors are often external and arise from occurrences outside thecompany, such as a natural disaster.Types of VarianceCost Variances• A cost variance is a difference between an actual expenditure and the expected (orbudgeted) expenditure.• A cost variance can relate to virtually any kind of expense, ranging from elements ofthe cost of goods sold to selling or administrative expenses.• This variance is most useful as a monitoring tool when a business is attempting tospend in accordance with the amounts stated in its budget.• The cost variance formula is usually comprised of two elements, which are:• Volume variance. This is the difference in the actual versus expected unit volume ofwhatever is being measured, multiplied by the standard price per unit.• Price Variance. This is the difference between the actual versus the expected price ofwhatever is being measured, multiplied by the standard number of units.Material Variance• The difference between the standard cost of direct materials and the actual cost ofdirect materials that an organization uses for production is known as MaterialVariance.• Material Cost Variance Formula:• Standard Cost – Actual Cost• In other words, (Standard Quantity x Standard Price) – (Actual Quantity x ActualPrice)• Material Variance is further sub-divided into two heads:• Material Price Variance:• MPV = (Standard Price – Actual Price) x Actual Quantity• Material Usage Variance:• MUV = (Standard Quantity – Actual Quantity) x Standard PriceLabor Variance• Labor Variance arises when there is a difference between the actual cost associatedwith a labour activity from the standard cost.• Labor Variance Formula:• Standard Wages – Actual Wages• In other words, (Standard Hours x Standard Rate) – (Actual Hours x Actual Rate)• Labor Variance is further sub-divided into two heads:• Labor Rate Variance:• LRV = (Standard Rate – Actual Rate) x Actual Hours• Labor Efficiency Variance:• LEV = (Actual Hours – Standard Hours) x Standard RateOverhead (Variable Variance)• Variable Overhead Variance arises when there is a difference between theactual variable overhead and the standard variable overhead based onbudgets.• Variable Overhead Variance Formula:• Standard Variable Overhead – Actual Variable Overhead• In other words, (Standard Rate – Actual Rate) x Actual Output• Variable Overhead Variance is further sub-divided into two heads:• Variable Overhead Efficiency Variance:• VOEV = (Actual Output – Standard Output) x Standard Rate• Variable Overhead Expenditure Variance:Fixed Overhead Variance• It arises when there is a difference between the standard fixed overhead for actualoutput and the actual fixed overhead.• Fixed Overhead Variance Formula:• = (Actual Output x Standard Rate per unit) – Actual Fixed Overhead• Fixed Overhead Variance is further sub-divided into two heads:• Fixed Overhead Expenditure Variance:• FOEV = Standard Fixed Overhead – Actual Fixed Overhead• Fixed Overhead Volume Variance:• FOVV = (Actual Output x Standard Rate per unit) – Standard Fixed OverheadSales Variance• Sales Variance is the difference between the actual sales and budgeted salesof an organization.• Sales Variance Formula:• = (Budgeted Quantity x Budgeted Price) – (Actual Quantity x Actual Price)• Sales Variance is further sub-divided into two heads:• Sales Volume Variance:• SVV = (Budgeted Quantity – Actual Quantity) x Budgeted Price• Sales Price Variance:• SPV = (Budgeted Price – Actual Price) x Actual QuantityBudget Control• Budgetary control refers to how well managers utilize budgets to monitor andcontrol costs and operations in a given accounting period.• Budgetary control is a process for managers to set financial and performance goalswith budgets, compare the actual results, and adjust performance, as it is needed.Steps of Budget Control Process• Establish actual Position: All organizations have some form of an accounting systemwhich records their income and expenditure• Compare actual with budget: After step 1, information gathered needs be comparedto the budgeted figures set at the beginning of the financial year• Control variance: In the context of budgetary control, the term variance refers to thedifference between actual and budget (planned) income and expenditureBudget Control Cont.• Establish reason for variance: There are several reasons that can account fordifferences found between the budgeted and actual expenditure. The reasons forall variances needs to be identified• Take Action: Budgets can only be controlled if corrective action is taken inresponse to the variances.• Sometimes the explanation for the variance results in no action being required.Quick CheckClass ActivityDiscuss among yourselves the following• Variance and the various types of variance• In your own words what is budget control?
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