Budgeting and Budgetary Control

Budgeting and Budgetary Control

Syllabus tag: KASNEB CPA | Intermediate Level | CA25 Management Accounting | Topic 5 Budgeting and Budgetary Control

Lesson objectives

By the end of this topic, you will be able to:

• Prepare a production budget from a sales budget
• Prepare materials purchases and labour budgets
• Prepare a simple cash budget allowing for credit terms
• Flex a budget to actual activity and explain why that matters
• Compare incremental, zero-based and rolling budgets
• Describe the behavioural effects of budgets

Why this matters

A budget nobody can be held to is decoration. This topic covers both halves: building the budget, and then using it to control — which only works if the comparison is made fairly.

The budget chain

Budgets are prepared in a fixed order, because each feeds the next. The chain starts at the principal budget factor — the constraint that limits everything else. Usually that is sales demand, but it can be a machine, a material or cash.

Sales budget → production budget → materials, labour and overhead budgets → cash budget → budgeted income statement and balance sheet.

Production budget

Production is not the same as sales. It must also cover the change in finished goods inventory.

Production = Sales + Closing inventory − Opening inventory

Sales 24,000 units, opening finished goods 1,500, closing 2,100:

= 24,000 + 2,100 − 1,500 = 24,600 units

The signs catch people out. Building inventory means producing more than you sell, so closing is added and opening deducted.

Materials purchases budget

Two steps, and the same logic applies a second time.

Material needed = 24,600 units × 3 kg = 73,800 kg

Purchases = Usage + Closing inventory − Opening inventory

With opening raw material 4,000 kg and closing 5,200 kg:

= 73,800 + 5,200 − 4,000 = 75,000 kg

At KES 150 per kg: KES 11,250,000

Labour budget

24,600 units × 1.5 hours = 36,900 hours

At KES 380 per hour: KES 14,022,000

Cash budget

Cash budgets differ from profit statements in two ways: they follow receipts and payments rather than income and expense, and they exclude depreciation entirely, since no cash moves.

Sales are KES 9,000,000 in month 1 and KES 10,500,000 in month 2. Customers pay 60% in the month of sale and 40% the month after.

Month 2 receipts = (10,500,000 × 0.60) + (9,000,000 × 0.40) = 6,300,000 + 3,600,000 = KES 9,900,000

A profitable company can still run out of cash, which is exactly what the cash budget exists to warn about in advance.

Flexing the budget

This is the most important idea in the topic.

A budget set for 20,000 units cannot fairly be compared with actual results at 23,000 units. Costs should be higher — more was made.

Budget: variable cost KES 250 per unit, fixed costs KES 3,000,000.

	Original budget (20,000)	Flexed budget (23,000)	Actual
Variable cost	5,000,000	5,750,000
Fixed cost	3,000,000	3,000,000
Total	8,000,000	8,750,000	8,900,000

Against the flexed budget the variance is 150,000 adverse.

Against the original budget it would appear to be 900,000 adverse — six times larger, and mostly nonsense, because 750,000 of it is simply the cost of making 3,000 extra units.

:::checkpoint A production manager is shown a 900,000 adverse variance and asked to explain it. Set out what you would say, and state what the report should have shown instead. :::

Approaches to budgeting

Incremental. Last year plus a percentage. Quick, and it carries forward every inefficiency that was in last year's figures.

Zero-based. Every activity must justify its whole cost from nothing. Thorough, and expensive in management time. Best used periodically rather than annually, or on discretionary areas such as training and marketing.

Rolling (continuous). As one month ends another is added, so a full twelve months is always in view. Suits volatile conditions and costs more to maintain.

Activity-based. Budgets built from expected activity volumes and their drivers, following the same logic as ABC.

Behavioural effects

A budget is a target set for people, so it changes how they behave.

• Budget slack. A manager who will be judged against a target has every incentive to negotiate an easy one.
• The use-it-or-lose-it effect. Underspending this year often means a smaller allocation next year, which encourages wasteful spending in the final quarter.
• Short-termism. Cutting training or maintenance improves this year's variance and damages the business.
• Participation. Budgets that managers help set are more likely to be accepted — and more likely to contain slack.

The design question is always whether the budget is being used to plan, to control, or to evaluate people. The same figures rarely serve all three well.

:::checkpoint A department spends heavily on unnecessary items each December. Name the behavioural effect at work and suggest one change to the budgeting system that would reduce it. :::