Definition
The principal budget factor is the factor which limits the activities of an organisation.
The first task in the budgetary process is to identify the principal budget factor. This is also known as the key budget factor or limiting budget factor.
The principal budget factor is usually sales demand. A company is usually restricted from making and selling more of its products because there would be no sales demand for the increased output at a price which would be acceptable/profitable to the company. The principal budget factor may also be machine capacity, distribution and selling resources, the availability of key raw materials or the availability of cash.
Once the principal budget factor is defined then the remainder of the budgets can be prepared. For example, if sales are the principal budget factor then the production manager can only prepare the production budget after the sales budget is complete.
A useful assumption for preparing the first draft of the functional budgets is to assume that sales demand is the principal budget factor. If it then becomes apparent that a scarce resource is the principal budget factor, the functional budgets can be revised and new drafts prepared.
The stages involved in the preparation of a budget with sales as the limiting factor can be summarised as follows.
(a) The sales budget is prepared in units of product and sales value. The finished goods inventory budget can be prepared at the same time. This budget decides the planned increase or decrease in finished goods inventory levels.
(b) With the information from the sales and inventory budgets, the production budget can be prepared. This is, in effect, the sales budget in units plus (or minus) the increase (or decrease) in finished goods inventory. The production budget will be stated in terms of units.
(c) This leads on logically to budgeting the resources for production. This involves preparing a materials usage budget, machine usage budget and a labour budget.
3: Budgeting 71 (d) In addition to the materials usage budget, a materials inventory budget will be prepared, to
decide the planned increase or decrease in the level of inventories held. Once the raw materials usage requirements and the raw materials inventory budget are known, the purchasing department can prepare a raw materials purchases budget in quantities and value for each type of material purchased.
(e) During the preparation of the sales and production budgets, the managers of the cost centres of the organisation will prepare their draft budgets for the department overhead costs. Such overheads will include maintenance, stores, administration, selling and research and development.
(f) From the above information a budgeted statement of comprehensive income can be produced.
(g) In addition several other budgets must be prepared in order to arrive at the budgeted statement of financial position. These are the capital expenditure budget (for non-current assets), the working capital budget (for budgeted increases or decreases in the level of receivables and payables as well as inventories), and a cash budget.
3 Preparing functional operating budgets
Section overview
• A functional (or departmental) budget is a budget forecasting income and expenditure for a particular department or process. It could be a production budget, a sales budget or purchasing budget depending on the function and the nature of its activities.
Worked Example: Preparing a materials purchases budget
ECO Ltd manufactures two products, S and T, which use the same raw materials, D and E. One unit of S uses 3 litres of D and 4 kilograms of E. One unit of T uses 5 litres of D and 2 kilograms of E. A litre of D is expected to cost $3 and a kilogram of E $7.
The sales budget for 20X2 comprises 8,000 units of S and 6,000 units of T; finished goods in stock at 1 January 20X2 are 1 500 units of S and 300 units of T, and the company plans to hold inventories of 600 units of each product at 31 December 20X2.
Inventories of raw material are 6,000 litres of D and 2,800 kilograms of E at 1 January and the company plans to hold 5,000 litres and 3,500 kilograms respectively at 31 December 20X2.
The warehouse and stores managers have suggested that a provision should be made for damages and deterioration of items held in store, as follows:
Product S: loss of 50 units Product T: loss of 100 units Material D: loss of 500 litres Material E: loss of 200 kilograms
Prepare a material purchases budget for the year 20X2.
LO 3.3
Management Accounting
72
Solution
To calculate material purchases requirements first it is necessary to calculate the material usage requirements. That in turn depends on calculating the budgeted production volumes.
Product S Product T
Units Units
Production required
To meet sales demand 8 000 6 000
To provide for inventory loss 50 100
For closing inventory 600 600
8 650 6 700
Less inventory already in hand 1 500 300
Budgeted production volume 7 150 6 400
Material D Material E
Litres Kgs
Usage requirements
To produce 7 150 units of S 21 450 28 600
To produce 6 400 units of T 32 000 12 800
To provide for inventory loss 500 200
For closing inventory 5 000 3 500
58 950 45 100
Less inventory already in hand 6 000 2 800
Budgeted material purchases 52 950 42 300
Unit cost $3 $7
Cost of material purchases $158 850 $296 100
Total cost of material purchases $454 950
The basics of the preparation of each functional budget are similar to the above.
4 Cash budgets
Section overview
• The cash budget is one of the most important planning tools that an organisation can use. It shows the cash effect of all plans made within the budgetary process.
Definition
A cash budget is a statement in which estimated future cash receipts and payments are tabulated in such a way as to show the forecast cash balance of a business at defined intervals.
Worked Example: Cash position
In December 20X2 an accounts department might wish to estimate the cash position of the business for the following months, January to March 20X3. A cash budget might be drawn up in the following format:
Jan Feb Mar
$ $ $
Estimated cash receipts
From credit customers 14 000 16 500 17 000
From cash sales 3 000 4 000 4 500
Proceeds on disposal of non-current assets 2 200
Total cash receipts 17 000 22 700 21 500
Estimated cash payments
To suppliers of goods 8 000 7 800 10 500
To employees (wages) 3 000 3 500 3 500
LO 3.4
3: Budgeting 73
Jan Feb Mar
$ $ $
Purchase of non-current assets 16 000
Rent and rates 1 000
Other overheads 1 200 1 200 1 200
Repayment of loan 2 500
14 700 28 500 16 200
Net surplus/(deficit) for month 2 300 (5 800) 5 300
Opening cash balance 1 200 3 500 (2 300)
Closing cash balance 3 500 (2 300) 3 000
In the example above, where the figures are purely for illustration, the accounts department has calculated that the cash balance at the beginning of the budget period, 1 January, will be $1 200. Estimates have been made of the cash which is likely to be received by the business (from cash and credit sales, and from a planned disposal of non-current assets in February). Similar estimates have been made of cash due to be paid out by the business - payments to suppliers and employees, payments for rent, rates and other overheads, payment for a planned purchase of non-current assets in February and a loan repayment due in January.
From these estimates it is a simple step to calculate the excess of cash receipts over cash payments in each month. In some months cash payments may exceed cash receipts and there will be a deficit for the month;
this occurs during February in the above example because of the large investment in non-current assets in that month.
The last part of the cash budget above shows how the business's estimated cash balance can then be rolled along from month to month. Starting with the opening balance of $1 200 at 1 January a cash surplus of
$2 300 is generated in January. This leads to a closing January balance of $3 500 which becomes the opening balance for February. The deficit of $5 800 in February throws the business's cash position into overdraft and the overdrawn balance of $2 300 becomes the opening balance for March. Finally, the healthy cash surplus of $5 300 in March leaves the business with a favourable cash position of $3 000 at the end of the budget period.