Budgeting

Two importance of sales planning:

1. It gives the basis for all other budgets (production, purchase, cash), since sales volume drives them.
2. It sets targets and helps allocate resources, and permits comparison of actual with planned sales to control performance.

The experience curve shows that as the cumulative volume of production doubles, the total unit cost (including production, marketing and administration) falls by a constant percentage, typically 20 to 30 percent, because of learning, specialisation, scale and process improvement.

Fixed cost is a cost that stays constant in total within the relevant range of activity regardless of the volume of output or sales, for example rent, salaries of permanent staff and insurance. Per-unit fixed cost falls as output rises.

Two objectives of budgeting:

1. To plan and coordinate the activities of all departments towards the organisation's goals.
2. To control performance and costs by comparing actual results with budgeted figures and taking corrective action.

Assumption: fixed cost is Rs 90,000 including depreciation of Rs 30,000 (a non-cash item); variable cost is Rs 6 per unit and selling price is Rs 11 per unit.

Cash fixed cost $= 90{,}000 - 30{,}000 =$ Rs 60,000

Contribution per unit $= 11 - 6 =$ Rs 5

$\text{Cash BEP (units)} = \frac{\text{Cash fixed cost}}{\text{Contribution per unit}} = \frac{60{,}000}{5} = 12{,}000 \text{ units}$

Cash BEP in sales value $= 12{,}000 \times 11 =$ Rs 132,000.

The closing inventory of each month is 50% of the next month's sales. The opening inventory of April equals 50% of April sales, because last month's closing stock followed the same policy.

The inventory figures are taken to be at retail value, and the initial mark-up of 20% is on retail, so cost is 80% of retail.

Open-to-buy at retail $= 65{,}000 - 25{,}000 =$ Rs 40,000

$\text{Open-to-buy at cost} = 40{,}000 \times (1 - 0.20) = \text{Rs } 32{,}000$

• Opening stock $= 40\% \times 20{,}000 = 8{,}000$ units
• Closing stock $= 30\% \times 20{,}000 = 6{,}000$ units

$\text{Sales} = \text{Opening stock} + \text{Production} - \text{Closing stock} = 8{,}000 + 20{,}000 - 6{,}000 = 22{,}000 \text{ units}$

Total sales $= 200{,}000$ units at Rs 20 per unit.

Cost of goods sold is 60% of sales, since the gross profit margin is 40%. Closing stock equals the next month's cost of sales. January's opening stock is taken as equal to January's cost of sales, following the same policy.

Profit planning and control (PPC) is a systematic and integrated approach to managing the whole operation of a firm so that a target profit is achieved. It involves setting profit goals, preparing plans and budgets to reach them (planning), and comparing actual results with the plans and taking corrective action (control). The main tools are the master budget (sales, production, cost, cash and capital budgets), standard costing, cost-volume-profit analysis and performance reporting.

Objectives of profit planning and control

1. Define and achieve profit goals: to translate the long-term objectives of the firm into a specific, measurable profit target for the coming period.
2. Coordination: to bring the plans of all departments (sales, production, purchasing, finance) into one consistent plan so that they pull in the same direction.
3. Communication: to inform all managers and employees of the goals, policies and expected performance.
4. Efficient use of resources: to allocate scarce resources such as cash, materials, labour and capacity to the most profitable uses and avoid waste.
5. Control and performance evaluation: to provide standards against which actual results are compared, variances are found and responsibility is fixed.
6. Motivation: to involve managers in setting targets so that they commit to achieving them.
7. Anticipating problems: to forecast shortages of cash, materials or capacity early enough to act.
8. Basis for decision making: to supply information for pricing, product mix and expansion decisions.

Just in time (JIT) is a management philosophy and production system in which materials, components and products are purchased or produced only when they are needed, in the quantity needed, so that inventories are kept at (or near) zero. Production is pull-driven by customer demand rather than push-driven by forecasts. Its main features are small lot sizes, close ties with a few reliable suppliers, quality at source (zero defects), a flexible multi-skilled workforce and short set-up times.

Implications of JIT in profit planning and control

1. Inventory budgets: raw material, work-in-process and finished goods balances are planned at very low levels, so the budgeted closing stock is small and production almost equals sales in each period.
2. Production and purchases budgets: purchases are scheduled in frequent small deliveries matched to the production schedule, which simplifies the material purchase budget.
3. Cost savings and profit: lower holding, storage, insurance, obsolescence and handling costs, and less working capital tied up in stock, raise budgeted profit.
4. Cash budget: less cash is invested in inventory, improving cash flow and reducing financing needs and interest.
5. Quality and standards: since defects stop the line, rework and scrap costs fall and standards can be set tighter.
6. Cost control and performance reports: costs become more traceable to cells and products, and control focuses on lead time, quality and delivery rather than only on cost variances.
7. Risk: forecasting accuracy and supplier reliability become critical, because there is no safety stock.

Performance report: a performance report is a periodic report that compares the actual results of a responsibility centre (department, manager or product) with the budgeted or standard figures, and shows the variances (favourable or unfavourable) between them. It usually highlights the controllable items for which the manager is responsible, so that attention can be given to significant variances (management by exception).

Why it is prepared

1. Control: to find out how far actual results deviate from the plan and to take corrective action in time.
2. Evaluation of managers: to judge the performance of responsibility centres and managers on controllable items.
3. Fixing responsibility: to identify who is accountable for each variance.
4. Feedback and communication: to give managers timely information about what has happened and why.
5. Motivation: to encourage managers to meet targets when performance is measured and rewarded.
6. Future planning: to revise budgets and standards and improve forecasting in later periods.

Open-to-buy is the amount of merchandise (at retail) that a store may still buy during the period without exceeding its planned stock.

Planned purchases at retail = Planned sales + Planned reductions + Planned ending stock − Beginning stock

$=90{,}000+4{,}000+30{,}000-8{,}000=\text{Rs }116{,}000$

Open-to-buy at retail = Planned purchases − Merchandise received to date − Stock on order

$=116{,}000-28{,}000-4{,}000=\text{Rs }84{,}000$

Check using the position to date: current stock = 8,000 + 28,000 − 20,000 − 2,000 = 14,000; remaining sales 70,000 + remaining reductions 2,000 + ending stock 30,000 − current stock 14,000 − on order 4,000 = 84,000.

Open-to-buy at cost (mark-up 20% on cost, so retail = 120% of cost):

$\frac{84{,}000}{1.20}=\text{Rs }70{,}000$

Open-to-buy: Rs 84,000 at retail (Rs 70,000 at cost).

Sales mix A : B = 3 : 2.

Contribution per unit: A = 100 − 80 = Rs 20; B = 200 − 100 = Rs 100

Contribution of one standard mix (3A + 2B) = 3 × 20 + 2 × 100 = Rs 260 for 5 units, so weighted average contribution per unit = 260 / 5 = Rs 52.

(i) Overall BEP

$\text{BEP units}=\frac{400{,}000}{52}\approx 7{,}692\text{ units}$

In mixes: 400,000 / 260 = 1,538.46 mixes, which gives A = 4,615 units and B = 3,077 units (about 7,692 in total).

(ii) Units for after-tax profit of Rs 150,000

Profit before tax = 150,000 / (1 − 0.25) = Rs 200,000

$\text{Units}=\frac{400{,}000+200{,}000}{52}\approx 11{,}538\text{ units}$

Split in 3 : 2: A = 6,923 units and B = 4,615 units (about 11,538 in total).

Evaluation

• Both companies earn the same profit at the same sales, but their cost structures differ. X has a low fixed cost and high variable cost; Y has a high fixed cost and low variable cost.
• Y has the higher P/V ratio, so each extra rupee of sales adds Rs 0.80 to profit against Rs 0.60 in X. If sales rise by 10%, profit rises by 20% in Y and by 15% in X.
• Y has the higher break-even point and the lower margin of safety, and a higher operating leverage, so it is riskier. A fall of 10% in sales cuts profit by 20% in Y but only 15% in X.
• X is more stable and safer in a recession or when demand is uncertain; Y is better when sales are expected to grow. X's profit also becomes positive at a lower sales level.

Material requirement = Production × standard usage. Purchases = Requirement + Closing stock − Opening stock, with closing stock = 50% of the next month's requirement. The opening stock of Baishakh is taken as 50% of its own requirement (the closing stock policy of the previous month).

Material A (2 units per unit; Rs 4 per unit)

Material B (1 unit per unit; Rs 5 per unit)

Material purchase budget (Rs)

Zero-based budgeting (ZBB) is a budgeting technique in which every activity and expense is justified afresh each period as if the budget were being prepared for the first time. Last year's spending is not taken as the base. Managers prepare decision packages for each activity, give alternatives and levels of effort, rank the packages by benefit and cost, and funds are allocated down the ranking until resources run out. The statement is largely correct, and the three claims can be discussed in turn.

1. Improving cost control

• Every cost must be justified, so unnecessary or inflated items cannot be carried forward from the earlier year (as happens with incremental budgeting).
• Costs are linked to specific activities and outputs, so managers know what each rupee buys and spending can be monitored against the package.
• Budget "padding" and the "spend it or lose it" habit are discouraged.

2. Increasing efficiency by eliminating waste

• Each activity is reviewed with alternatives (make or buy, centralise or decentralise, different service levels), so cheaper and more efficient ways are found.
• Low-priority, obsolete or duplicated activities fall below the cut-off line and are dropped, releasing funds for better uses.
• Resources are shifted from low-return to high-return activities, and the ranking gives a clear basis for cuts when funds are short.

3. Better alignment with strategic goals

• Decision packages are ranked against the objectives of the organisation, so funds follow priorities instead of history.
• It involves managers at all levels in planning, which improves communication, ownership and understanding of the goals.
• It is flexible when the environment changes, because the whole budget is re-examined.

Limitations (why the claim holds only partly)

• It is time-consuming, paper-heavy and costly, since all activities are reviewed every year.
• Managers need training; ranking of intangible activities (e.g. training, research, welfare) is subjective.
• Short-term cost cutting may be favoured over long-term investment, and managers may resist because it threatens their budgets.
• It may be unsuitable for activities with fixed commitments.

Conclusion: ZBB does improve cost control, remove waste and align spending with strategy when properly applied, particularly in service departments, government and non-profit bodies. Because of its cost and effort, many organisations apply it in rotation (for example every three to five years) or to selected departments.

Cost-volume-profit (CVP) analysis studies the relationship between cost, sales volume and profit. It separates costs into fixed and variable and uses the contribution margin to show how profit changes when output, price or cost changes. The statement is correct: CVP shows the financial results of the firm at different activity levels.

Basic relationships

$\text{Profit}=(\text{SP}-\text{VC})\times Q-\text{Fixed cost}$

$\text{BEP (units)}=\frac{\text{Fixed cost}}{\text{CM per unit}},\qquad \text{BEP (sales)}=\frac{\text{Fixed cost}}{\text{P/V ratio}}$

$\text{Units for target profit}=\frac{\text{Fixed cost}+\text{Target profit}}{\text{CM per unit}}$

Margin of safety = Actual sales − Break-even sales.

How CVP shows the effect of activity levels

1. Break-even point: it shows the sales level at which there is no profit and no loss. Below it the firm makes a loss and above it a profit.
2. Profit at different volumes: each extra unit sold adds its contribution margin to profit once fixed costs are covered, so the profit at any planned volume can be computed or read from the break-even chart.
3. Target profit: it gives the volume needed for a desired before-tax or after-tax profit.
4. Margin of safety: it shows how far sales can fall before a loss arises.
5. Operating leverage: a firm with high fixed costs shows larger swings in profit for a given change in sales.
6. "What-if" analysis: the effect of changes in price, variable cost, fixed cost and sales mix can be tested before deciding.

Uses in decision making: pricing, product mix with limited resources, make or buy, plant expansion or shutdown, and budget planning.

Assumptions and limits: costs can be split into fixed and variable and behave linearly within the relevant range; selling price is constant; sales mix is constant; production equals sales; efficiency does not change. These assumptions hold only approximately in practice, so results are valid only over the relevant range.

Conclusion: despite its assumptions, CVP is a simple and powerful tool to analyse how different levels of activity affect revenue, cost and profit, and to plan and control the business.

(a) Volume of work (activity)

Service department (repair hours): 0.3 per DMH of X = 2,800 × 0.3 = 840 hours; 0.2 per DLH of Y = 3,900 × 0.2 = 780 hours. Total repair hours = 1,620.

(b) Overhead rates

Service department rate = 12,000 / 1,620 = Rs 7.4074 per repair hour.

(c) Cost of goods manufactured

Check: total overhead absorbed = 34,884.01 + 59,116.00 = 94,000 = 40,000 + 42,000 + 12,000.

(a) Direct labour cost budget

Standard hours = units × standard hours per unit; cost = hours × rate.

(b) Performance report, Department A, January

Budget flexed to actual output: 5,200 units × 2 hrs = 10,400 standard hours × Rs 10 = Rs 104,000.

Analysis of the variance:

• Labour rate variance = (SR − AR) × AH = (10 − 11) × 9,360 = Rs 9,360 Unfavourable
• Labour efficiency variance = (SH − AH) × SR = (10,400 − 9,360) × 10 = Rs 10,400 Favourable
• Net variance = Rs 1,040 Favourable

Against the original budget of Rs 100,000 (5,000 units) the actual cost is Rs 2,960 higher, but this arises only from the 200 extra units produced. Department A used fewer hours than standard but paid a higher wage rate, so the rate (Rs 11 against Rs 10) should be investigated.

Assumptions: opening accounts payable and receivable are settled in Baishakh; the fixed administrative and selling expenses of Rs 50,000 per month are paid in cash; depreciation at 15% p.a. is charged on plant (Rs 300,000), i.e. Rs 3,750 per month; the bonds are redeemed on Baishakh 31 with a month's interest of Rs 1,000; bank loans are drawn at the start of the month in which cash is short and repaid, earliest first, at the end of Ashadh. Production cost per unit = material 6 kg × Rs 2 = 12, labour 4 × Rs 3 = 12, variable overhead 6, total Rs 30 (this agrees with the opening finished goods of Rs 150,000 for 5,000 units).

1. Material purchase budget

2. Cash receipts and disbursements budget (Rs)

3. Budgeted income statement (three months, Baishakh to Ashadh)

4. Budgeted balance sheet at the end of Ashadh 2082