l Mgmt Accounting StudyText Chapter 11

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Types of budget

chapter

contents

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11

learning outcomes

This chapter continues the syllabus sub-section entitled Medium-term planning and decision-

making. The specific syllabus topics are Fixed budgets, flexible budgets, rolling budgets and

ABB. After carefully working through the material contained in this chapter, you should be able

to:

Explain the limitations of using fixed budgets for control purposes.

Describe the reasons why actual results may vary from budgeted results.

Construct a flexible budget operating statement from given information.

Convert multi-product output figures into standard hours.

Explain the benefits of using flexible budgets for control and planning.

Prepare an activity-based budget from given information.

Explain the benefits to organisations of using an ABB system.

Explain the drawbacks of using fixed-period budgets.

Describe the mechanics of constructing rolling budgets.

Explain how rolling budgets can overcome fixed-period budgets problems.

Describe the potential problems with rolling budgets and how these may be overcome.

Recognise that flexible, activity-based and rolling budget systems are compatible.

1 Fixed budgets

2 Flexible budgets

3 Activity-based budgeting

4 Rolling/continuous budgets

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The aims of budgeting include planning, facilitating control and providing motiv-ation.Some of these aims may conflict.Such conflicts may be overcome by producingseparate budgets for planning from those prepared for control purposes. Forinstance, CIMA Official Terminology suggests that a fixed budget could be used for plan-ning and a flexible budget could be used for control purposes.

There are a variety of alternative approaches to budgeting.The best known arelisted below.The definitions are all taken from CIMA Official Terminology.

Fixed budget:A budget which is normally set prior to the start of an accountingperiod, and which is not changed in response to subsequent changes in activity orcosts/revenues. Fixed budgets are generally used for planning purposes. Fixedbudgets suffer from a number of disadvantages if used for control.These are elab-orated in section 1, below.

Flexible budget A budget which, by recognising different cost behaviourpatterns, is designed to change as volume of activity changes. Flexible budgets arecovered in section 2 below.

Activity-based budgeting (ABB): A method of budgeting based on an activityframework and utilising cost driver data in the budget-setting and variance feed-back process. See section 3 below for details on ABB.

Rolling/continuous budget:A budget continuously updated by adding a furtheraccounting period (month or quarter) when the earlier accounting period hasexpired. Its use is particularly beneficial where future costs and/or activitiescannot be forecast accurately.The mechanics and benefits of rolling budgets aredescribed in Section 4 of this chapter.

Incremental budgeting:A method of budget setting in which the prior periodbudget is used as a base for the current budget,which is set by adjusting the priorbudget to take account of any anticipated changes. For example, if activity levelsare expected to be unchanged the budget for the coming year is simply based onthe current years budget, plus an increase or decrease to compensate for expectedprice changes.This method is crude and cannot be recommended, as it does notstimulate managers to continually improve efficiency levels.

Zero-based budgeting: A method of budgeting which requires each costelement to be specifically justified, as though the activities to which the budgetrelates were being undertaken for the first time. Without approval, the budgetallowance is zero. Zero-based budgeting (ZBB) attempts to overcome the defectsof incremental budgeting by requiring managers to obtain detailed approval forall projected expenditure. While the principle is sound the ZBB process canbecome over-bureaucratic, costly and time-consuming. For this reason, full ZBBsystems are rare.

This chapter, and the syllabus, is restricted to fixed, flexible, rolling/continuous andactivity-basedbudgetingsystems.Incrementalbudgetingcan scarcely be describedasa system, while ZBB is not used widelyenough to justify its inclusion in the syllabus.

1 Fixed budgets

Before looking at the various other types of budget we should consider why fixedbudgets are unsuitable for control purposes.

1.1 Variances

Chapter 3 section 5.3 explains that in budgetary control systems, actual revenues andexpenditures are compared with budgeted figures to identify variances.A variance isdefined as The difference between a planned, budgeted or standard cost and theactual cost incurred.The same comparison may be made for revenues (CIMA OfficialTerminology).

11 TYPES OF BUDGET 199

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incremental budgeting

A method of budget settingin which the prior period

budget is used as a base for

the current budget, which is

set by adjusting the prior

budget to take account of

any anticipated changes.

zero-based budgeting

A method of budgeting

which requires each cost

element to be specifically

justified, as though the

activities to which thebudget relates were being

undertaken for the first time.

Without approval, the

budget allowance is zero.

fixed budget

A budget which is normally

set prior to the start of an

accounting period, and

which is not changed in

response to subsequent

changes in activity or

costs/revenues. Fixed

budgets are generally used

for planning purposes.

variance

The difference between a

planned, budgeted or

standard cost and the actual

cost incurred. The same

comparison may be made for

revenues.

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200 MEDIUM-TERM PLANNING AND DECISION-MAKING


An adverse varianceoccurs when actual revenue is less than budget or actual costis higher than budget, while if actual revenue is higher than budget or actual cost isbelow budget the difference is described as a favourable variance.

Please note that in this text adverse variances in operating statements are shown inbrackets.This is normal practice, and should be followed at all times in the examin-

ation.The reason is that figures in brackets are easier to see than if initials or words areused to distinguish between favourable and adverse variances. For example,100,000F and 100,000A can look similar on an operating statement, whereas100,000 and (100,000) are clearly different.

1.2 Reasons for variances

There are three reasons why the actual revenue achieved in a budget period maydiffer from the budgeted revenue.

1 The most likely is that the quantity sold may be more or less than that in thebudget.

2 Alternatively, if there is more than one product, the mix of sales may differ.3 There could be a difference between the budgeted and actual selling prices.

There are four reasons why the actual material costs, direct labour costs and variableproduction overheads incurred may be different from those budgeted.

1 The variances could be due to the higher, or lower, volume of sales causing thequantities of materials, direct labour and variable production overheadsconsumed, to exceed, or fall below, the budget.

2 Variances could also occur due to changes in the prices paid for materials, directlabour and variable production overheads.

3 The mix of materials, or the composition of the direct labour employed, couldalso vary from budget.

4 A change in the efficiency with which material, direct labour and variable produc-tion overheads are used could result in the quantities of these resources consumedbeing different from that in the budget.

Sales commission is the only other common variable cost. It should only vary frombudget if the sales revenue differs, or if there has been a change in the way in whichthe commission is calculated.

Actual fixed overhead costs should only differ from the budget if the actual pricesof the fixed overheads were different or if some of the fixed overhead costs had beenomitted from the budget.

All variable costs will differ from the budget if the sales volume is higher or lowerthan the budget. If the production managements performance is assessed against afixed budget and the actual sales are higher than the budget it is likely that there willbe adverse production cost variances. But these increases in the variable productioncosts are simply due to the actual sales volume being different from the budget, sothese volume variances are not really the responsibility of the production managers.

It has already been established (in Chapter 3 section 5.3) that, if we are to usebudgets for control purposes, then we should distinguish between controllable andnon-controllable costs.Therefore,budgetary control should concentrate on control-lable factors such as price, efficiency and mix. However, if we compare actual costswith a fixed budget, it will be difficult to isolate any variances that are due to changesin the actual prices, efficiency or mix (i.e.controllable variances),as they may well beswamped by the variances due to differing sales volumes (a non-controllable vari-ance).Therefore, fixed budgets are not really effective for control purposes.

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2 Flexible budgets

The ineffectiveness of fixed budgets for control purposes can be dealt with by usinga flexible budget instead. A flexible budget is designed to change as a businesssactivity increases or decreases.

2.1 Using sales volume to flex a budget

When the volume of sales differs from that which was budgeted it makes sense torevise the original budgets variable costs and revenues. For example if actual salesvolume is 10 per cent higher than the original budget we should increase the variablecosts budget by 10 per cent. Otherwise, those differences between the budget andactual figures that are solely due to volume differences will mask the variances due todifferences in purchases prices and usage efficiency.

worked example 11.1

Blackbags Ltd manufactures plastic bags used for rubbish disposal. The budgeted sales for last year were 10

million bags at a selling price of 0.05 each. Budgeted material costs were 0.02 per bag. All other costs were

fixed, and were budgeted at 250,000 for the year. The actual out-turn for the year was sales of 12 million

bags, while unit selling-prices, unit material prices and total fixed costs were exactly as budgeted.

Required

Prepare an operating statement, which compares Blackbags Ltds budgeted and actual results for the last year.

Answer

Blackbags Ltd Operating statement for the year ending XX/XX/XX

Budget Actual Variance Variance as per cent

of budget

Sales quantity 10,000,000 12,000,000 2,000,000 20 per cent

Revenue 500,000 600,000 100,000 20 per cent

Material costs 200,000 240,000 (40,000) (20 per cent)Contribution 300,000 360,000 60,000 20 per cent

Fixed cost 250,000 250,000 0 0

Profit 50,000 110,000 60,000 120 per cent

It appears from the above statement that the sales manager has contributed an extra 100,000 towards

profits, while the production manager has depressed profits by 40,000. In fact, the adverse materials cost

variance is entirely due to the 20 per cent increase in sales. What matters is the 20 per cent improvement in

total contribution, which has resulted in a 120 per cent improvement in profits.

test your knowledge 11.1

Why is fixed budgeting not very effective for control purposes?

flexible budget

A budget which, by

recognising different cost

behaviour patterns, is

designed to change as

volume of activity changes.

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2.2 Using flexible budgets for control purposes

Flexible budgets are particularly valuable for control purposes in manufacturingindustry because they can be used to remove those variances that are simply causedby actual sales volumes differing from the budget.

worked example 11.2

(Using the same facts as Worked Example 11.1)

Blackbags Ltd manufactures plastic bags used for rubbish disposal. The budgeted sales for the last year were

10 million bags at a selling price of 0.05 each. Budgeted material costs were 0.02 per bag. All other costs

are fixed, and were budgeted at 250,000 for the year. The actual outturn for the year was sales of 12 million

bags, while unit selling-prices, unit material prices and fixed costs were exactly as budgeted.

Required

Prepare a flexible budget operating statement, which compares Blackbags Ltds budgeted and actual results

for the last year.

Answer

Operating statement for the year ending XX/XX/XX

Original budget Flexed budget Actual Variance

Sales quantity 10,000,000 12,000,000 12,000,000 0

Revenue 500,000 600,000 600,000 0

Material costs 200,000 240,000 240,000 0

Contribution 300,000 360,000 360,000 0

Fixed cost 250,000 250,000 250,000 0

Profit 50,000 110,000 110,000 0

The sales volume is 20 per cent higher so we flex the original budget so that the budgeted revenue, material

cost and contribution are all 20 per cent higher. By flexing the budget, the above operating statement

eliminates the volume effect entirely and shows that there were no variances due to prices or efficiency

differing from budget. The only problem is that the sales managers achievement is not apparent. We can

portray the effect of the improvement in sales by adding a 60,000 favourable sales volume variance to the

end of the operating statement. The sales volume variance is the difference between the original budget profit

and the flexed budget profit, i.e. 110,000 50,000 60,000 favourable volume variance.

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While most examples in this text will show flexible budgets being used for control ina manufacturing context, the technique is just as useful for extractive industries andfor any service industries that have significant variable costs.

2.3 Standard hours

Budgeted and actual sales volumes can be measured in units, tonnes or litres if thereis a single product. It is more difficult to find a single measure for output if there is

more than one product. One solution is to use the standard time required to achievethe particular level of output. As you would expect, standard time is measured instandard hours and minutes.CIMA Official Terminology defines a standard hour or minuteas The amount of work achievable, at standard efficiency levels, in an hour orminute.The standard time may relate to machine hours if all output goes throughthe same, or similar, machines. Standard time can also relate to process hours, if alloutput goes through the same process. However, in most cases standard time relatesto direct labour hours, whether for a manufactured product or for a service.

worked example 11.3

(Figures based on the answer to Worked Example 11.2, but with different actual revenues and costs)

Blackbags Ltd manufactures plastic bags used for rubbish disposal. The budgeted sales for the last year were

10 million bags at a selling price of 0.05 each. Budgeted material costs were 0.02 per bag. All other costs

are fixed, and were budgeted at 250,000 for the year.

The flexible budget operating statement is set out below.

Operating statement for the year ending XX/XX/XX

Original budget Flexed budget Actual Variance

Sales quantity 10,000,000 12,000,000 12,000,000 0

Revenue 500,000 600,000 550,000 (50,000)

Material costs 200,000 240,000 230,000 10,000

Contribution 300,000 360,000 320,000 (40,000)

Fixed overheads 250,000 250,000 240,000 10,000

Profit 50,000 110,000 80,000 (30,000)Sales volume variance (Original budget profit flexed budget profit) 60,000

Required

Explain why the revenue variance is adverse and the material variance is favourable, when a comparison

between the original budget and the actual results appears to show the opposite.

Answer

If we had simply compared the actual results with the original budget the sales variance would have appeared

favourable, whereas in fact, the revenue did not rise by as great a proportion as the volume. Therefore, the

selling price must have gone down compared with the budget, and comparison with the flexible budget

identifies this, correctly, as an adverse variance. Similarly, although the materials costs are higher than the

original budget they are lower than would be expected for the level of sales achieved. This could be because

material prices were lower than budgeted or the quantity of material used for each bag was lower. Comparisonwith the flexible budget highlights the favourable material cost variance achieved.

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Most costs vary with input-based activity levels, e.g. direct wages vary with directhours worked. However, the flexible budget allowance should be based on outputmeasures, such as tonnes delivered or standard hours produced.This will highlight

the efficiency with which resources are used. So, we should identify those costs andrevenues that vary with output and amend the budget to reflect actual activity, beforecomparing it with actual costs and revenues.

2.4 Format for flexible budget operating statements

Flexible budgeting can be used in both marginal and absorption costing systems.In an absorption costing system the fixed costs are also flexed to match output.This approach is misleading as it implies that fixed costs are variable, and sorequires a volume variance to be calculated if any over- or under-spends are tobe isolated. Many managers find flexed absorption costing budgets confusing. Ifyou prepare a flexible budget in the examination it should always have a marginalcosting format.

worked example 11.4

Crewed Fabrications manufactures fibreglass canoes. The manufacturing process is very labour-intensive.

Crewed Fabrications make three products, two-seat, four-seat and eight-seat canoes. It takes five direct labour

hours to build a two-seat canoe. Four-seat canoes require eight direct labour hours and eight-seat canoes

fourteen direct labour hours.

Set out below are the standard direct labour-hours for each type of canoe, plus the budgeted and actual

outputs of each type for the last month.

Type of canoe: 2 seats 4 seats 8 seats Total

Standard direct hours per canoe 5 8 14 n.a.

Budgeted output for the month 100 100 100 300

Actual output in the month 200 50 50 300

Required

Compare the budgeted and actual standard hours produced in the last month.

Answer

Type of canoe: 2 seats 4 seats 8 seats Total

Standard direct hours per canoe 5 8 14 n.a.

Budgeted output for the month (units) 100 100 100 300

Actual output in the month (units) 200 50 50 300

Budgeted output for the month (standard hours) 500 800 1,400 2,700

Actual output in the month (standard hours) 1,000 400 700 2,100

Variance (standard hours) 500 (400) (700) (600)

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worked example 11.5

Salamander Lamps Ltd make a single type of garden floodlight. The budgeted and actual results for the last

month are set out below. As the company operates JIT purchasing and manufacturing systems its opening and

closing stocks are not significant.

Budget Actual Variances

Units sold 10,000 11,000 1,000

Sales revenue 250,000 255,000 5,000

Costs:

Materials 45,000 48,600 (3,600)

Labour 60,000 71,400 (11,400)

Variable overhead 30,000 40,000 (10,000)

Production overheads 35,000 38,000 (3,000)

Selling overheads 15,000 13,000 2,000

Administration 20,000 21,000 (1,000)

Total costs: 205,000 232,000 (27,000)

Profit (loss) 45,000 23,000 (22,000)

Required

Prepare a revised operating statement in a marginal costing format that includes a flexible budget.

Answer

Flex the budgeted sales, variable costs and contribution by multiplying the original budget figures by 11,000

units 10,000 units, i.e. 110 per cent or 1.1.

Salamander Lamps Ltd Budgeted and actual results for the last month.

Original Budget Flexed budget Actual Variances

Units sold 10,000 11,000 11,000

Sales revenue 250,000 275,000 255,000 (20,000)

Variable costs:

Materials 45,000 49,500 48,600 900

Labour 60,000 66,000 71,400 (5,400)

Variable overhead 30,000 33,000 40,000 (7,000)

Total variable cost 135,000 148,500 160,000 (11,500)

Contribution 115,000 126,500 95,000 (31,500)

Fixed costs:

Production overheads 35,000 35,000 38,000 (3,000)

Selling overheads 15,000 15,000 13,000 2,000

Administration 20,000 20,000 21,000 (1,000)

Total fixed costs 70,000 70,000 72,000 (2,000)

Profit (loss) 45,000 56,500 23,000 (33,500)

Sales volume variance Flexed budget profit less original budget profit 11,500

2.5 The linear assumption

Budgets contain several activities so variations in their costs may not always be linear.For example, there may be bulk discounts, which affect material costs, learningeffects can affect labour costs and some fixed costs may, in fact, be stepped costs. Itmay be possible to construct appropriate cost and revenue formulae to deal with thisproblem.For instance,we could use

Material costs per unit which decrease each time the volume exceeds the bulkdiscount points.

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Material costs per unit, for scarce materials, which increase if the quantityrequired exceeds the quantities available from lower cost suppliers.

Labour costs per unit which decrease as cumulative output increases, due to thelearning effect.

Stepped supervision costs.

However, all calculation questions in the examination will be based on the linearassumption for revenue, variable costs and activity based costs. Questions will use afixed cost assumption for space costs and non-activity based overheads, unlessdistinct steps in these costs are necessary to fit the facts of the question.To recap:

For all revenue,or variable costs or activity-based costs,the budgeted revenues andcosts PER UNIT will be the same, irrespective of the volume change.

For those space costs and overheads that are not activity-based, the budgeted fixedcost figure will remain the same, whatever the volume, unless distinct steps aremore logical.

2.6 Flexible budgets for planning

Flexible budgeting can be used at the budget planning stage to test the effects ofalternative activity levels.

theory into practice 11.1

Set out below is next years budget for Angouleme Ltd. Prepare a budget comparison that shows the effects on

revenues, costs and profit if sales are 10 per cent below budget, 20 per cent below budget and 10 per cent

above budget.

Angouleme Ltd Budget for the coming year

Standard hours sold 100,000

Sales revenue 500,000

Variable costs:Materials 50,000

Labour 100,000

Variable overhead 20,000

Total variable cost 170,000

Contribution 330,000

Fixed costs:

Production overheads 150,000

Selling overheads 80,000

Administration 70,000

Total fixed costs 300,000

Profit (loss) 30,000

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2.7 Flexible budgets for performance appraisal

Flexible budgets can also be used as a basis for performance appraisal. However, asflexible budget calculations are approximations they should be used with care whenevaluating managerial performance. For instance, it is not only the number of itemsor standard hours produced which affect cost performance.Other factors,such as the

length of production runs, number of machine set-ups and the mix of activities orproducts can also affect cost performance.

theory into practice 11.1 continued

Answer

Angouleme Ltd Budget comparisons for the coming year

Volume assumption Original 90 per cent of 80 per cent of 110 per cent of

budget budget budget budget

Standard hours sold 100,000 90,000 80,000 110,000

Sales revenue 500,000 450,000 400,000 550,000

Variable costs:

Materials 50,000 45,000 40,000 55,000

Labour 100,000 90,000 80,000 110,000

Variable overhead 20,000 18,000 16,000 22,000

Total variable cost 170,000 153,000 136,000 187,000

Contribution 330,000 297,000 264,000 363,000

Fixed overhead:

Production overheads 150,000 150,000 150,000 150,000

Selling overheads 80,000 80,000 80,000 80,000

Administration 70,000 70,000 70,000 70,000

Total fixed costs 300,000 300,000 300,000 300,000

Profit (loss) 30,000 (3,000) (36,000) 63,000

Sales volume variance 0 (33,000) (66,000) 33,000


Explain why the linear assumption used for flexible budgeting may be a

simplification of the real movement in costs as volume changes.

3 Activity-based budgeting

Activity-based costing (ABC) can be used to produce more useful overheadbudgets.

Activity budgets canbe built up bymultiplying theplanned volumes of each productby the planned quantity of each cost driver consumed and the expected cost per unitof cost driver. This is known as Activity-Based Budgeting (ABB). Activity-basedbudgets canbe used for planning, andcontrol,bycombiningflexiblebudgetingprin-ciples with activity-based costing. However, it is critical to identify reliable service-units (or cost drivers),otherwiseyoumay alter thebudgetby the wrong factors.

3.1 The mechanics of ABB

ABC will give an organisation information on:

measurable activities;

values of cost pools;

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quantities of cost drivers for each activity;

standard costs per unit of each cost driver;

the standard consumption of cost drivers by each product.

Activity-based budgeting within an organisation will provide:

budgets for the use or consumption of activities i.e. the consumption of costdrivers;

budgets for the provision of activities.

Once the standard costs per unit of cost driver and the standard consumption of costdrivers per unit of each product have been established it is possible to:

translate the production or sales budgets for each product into quantities of costdrivers required;

translate the budgeted quantities of each cost driver required into financialbudgets for the provision of each activity.

Senior and operational management can then:

monitor the quantity of cost drivers consumed by each product, to encourage

improved efficiency of use; monitor the size of activities cost pools against the total consumption of cost

drivers. This will provide average costs per unit of cost driver, which can becompared with the budgeted figures to encourage reductions in the activitiescosts.

theory into practice 11.2

Geranium Engineering Ltd makes four types of air-compressor, the HP100, HP200, LP30 and LP60. The

company introduced ABC several years ago. It is now planning to introduce ABB. Set out below is a summary of

the information extracted from the ABC system concerning materials handling.

Cost pool for the materials handling activity in the last year, 75,000.

Cost driver is the number of materials movements.

Total number of materials movements in the last year, 15,000.

The relevant product information is

Product HP100 HP200 LP30 LP60

Budgeted output in the coming year (units) 3,000 8,000 2,500 4,800

Standard batch sizes (units) 15 20 5 15

Standard materials movements per batch 5 6 13 8

Required

(a) Calculate:

(i) the budgeted cost pool for materials handling in the coming year;

(ii) the standard handling cost per unit for each product.

Use last years actual figures for the materials handling cost pool and the number of materials movements as

your basis.

(b) Suggest five reasons why the actual value of the materials handling cost pool may differ from the budget

value in the coming year.

Answer

(a)

W1 The standard ABC per materials movement, based on last years actual figures,

Cost pool quantity of cost driver 75,000 15,000 5 per materials movement.

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3.2 The benefits of ABB

The benefits of ABB to an organisation are:

1 Budget setting will be more rational as it will be based on demand-side data (i.e.consumption) rather than just supply-side data.

2 The attribution of overhead costs to products will no longer be independent oftheir consumption of overhead resources.

3 Efficiency of use should be enhanced because each service consumed will attract aconsumption-related cost. Therefore, overhead services will cease to be a free

good.4 Economy of service provision within the organisation will be encouraged,as there

will be a link between budgeted and actual consumption and spend.

The key benefit of ABB is the establishment of explicit,but linked, responsibilities forthe management of services consumption and the management of servicesprovision.Therefore, a continuous improvement mentality can be instilled into theproviders and users of overhead activities.

theory into practice 11.2 continued

Product HP100 HP200 LP30 LP60 Total

Budgeted output in the coming year (units) 3,000 8,000 2,500 4,800

Standard batch sizes (units) 15 20 5 15

Budgeted batches 200 400 500 320


Budgeted materials movements 1,000 2,400 6,500 2,560 12,460

5 Budgeted materials handling cost pool () 62,300


5 Standard handling cost per unit 25 30 65 40

(b) Reasons why the actual cost pool may differ from the ABB in the coming year.

The batch sizes may differ from the budget.

The number of materials movements per batch may increase or decrease.

The output of each product may differ from budget.

The cost pool may be affected by price changes and labour rate changes.

The efficiency with which the materials handling activity is carried out may improve or deteriorate.


What are the benefits to an organisation of converting from an absorption costing

budgeting system to ABB?

4 Rolling/continuous budgets

The conventional budgeting practice is to prepare an annual budget well in advance,so that budget figures can be released to managers before the new budget year starts.This means that the budget preparation process may have to start as early as August orSeptember if the budget for the year commencing 1 January is to be ready for releasein early December.

4.1 Problems with the conventional annual budgeting process

There are a number of problems with the conventional annual budgeting process

rolling/continuous budget

A budget continuously

updated by adding a further

accounting period (month or

quarter) when the earlier

accounting period has

expired. Its use is

particularly beneficial where

future costs and/or activities

cannot be forecast

accurately.

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1 A budget, for the year beginning 1 January, which is issued to managers duringDecember, may be two or three months out of date before it is even used.Consequently, there will be differences in performance (i.e. variances) that are dueto out of date budget assumptions, unless the business and its operating environ-ment are extremely stable.

2 This obsolescence factor is likely to increase as the budget year progresses,until bythe last month of the budget year (month 12) the budget may well be useless forcontrol purposes it will simply have historical significance.

3 In some organisations,particularly in thepublic sector, thebudget isnotjustpart ofa control mechanism,it is a meansof allocating funds toactivities.Oneof thepecu-liar features of this approach is that budget surpluses cannot be carried forwardinto thenext budgetyear.Therefore, any moneybudgeted butnot spent iswastedas far as the manager of an activity or department is concerned.And,where incre-mentalbudgeting is inplace any money not spent in this year will result in a lowerbudgetnext year.Consequently, theremay bea bout ofpanicbuyingjustbefore theyear-end, firstly to use up allocated funds and secondly so as to provide a higherbase for next years budget allocations.This can result in normalvalue for moneyjudgementsbeingsuspended,and therefore, a waste of resources.

4 The annual budgeting cycle is designed to fit in with the external financialreporting timetable, not with the reality of the business cycle. The agriculturalyear, with its seasonal pattern may be appropriate for those businesses that havedistinct seasonal fluctuations in sales, but it is not relevant to many other busi-nesses such as aircraft manufacture, civil engineering, oil, pharmaceuticals andchemicals.

5 The once a year blitz involved in preparing the annual budget gets in the way ofnormal management activity and, because managers may have forgotten what thebudgeting processes and assumptions were in the previous year, re-learning maybe necessary.Also, once the budget has been set managers may forget about future,budget-related, issues and concentrate on immediate problems.

6 Finally, the annual budget process tends to focus managers short-term planninghorizons on the end of the budget year. This planning horizon will become

shorter as the year progresses, until, by months 10 and 11 some managers mayonly be looking one or two months ahead.

While flexible budgets will deal with any budget obsolescence caused by actualvolumes being different from the budget prediction,the other problems with annualbudgets will remain. One solution to the problem is to institute a rolling (orcontinuous) budgeting regime.

4.2 The mechanics of constructing rolling budgets

Rolling budgets involve updating a twelve-month budget every month or quarter.Where a rolling budget regime is in operation the annualbudget is regularly revisedby discarding the segment relating to the one or three-month period that has justelapsed and adding on a new segment to the far end of the budget.The new twelve-

month budget will then be revised to reflect current expectations.Rolling budgets can be set at two levels of detail. For instance, a detailed budget

may be prepared for the next three months, while less detailed broad brush figuresare used for the subsequent nine months.

Preparing rolling budgets can become time-consuming and expensive if theprocess is badly managed or if it is difficult to obtain the necessary data. However,spreadsheet modelling combined with a financial/operational database should mini-mise this problem.

4.3 The benefits and drawbacks of rolling/continuous budgeting

As the CIMA definition at the start of this chapter states, rolling budgets are particu-larly beneficial where future costs and/or activities cannot be forecast accurately.



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Rolling budgets are useful for coping with inflation, as well as being valuable forrapidly developing businesses and those firms that are committed to a policy ofcontinuous improvement. Rolling budgets are perfectly compatible with flexible andactivity-based budgeting.

The ways that a rolling budget avoids the problems listed at 4.1 above are:

1 As the budget is continuously updated it avoids being out of date before beingapplied.

2 The budget is unlikely to become obsolete by the second or third month of thefirst quarter.

3 A rolling budget, which is continuously updated,will do away with the year-endbuying spree intended to mop up surplus budget funds, because the year-end willnever be reached.Therefore, funds should be spent more wisely, and only whennecessary.

4 By doing away with the annual budgeting cycle, a rolling budget reinforces thereality that most commercial activity is a continuous process that does not havepauses in its activity (unlike education for example).

5 Managers should become more adept at budgeting because they would be contin-ually aware that the current budget would soon be due for an update.They would

also have to integrate budgeting with their normal activity rather than puttingimportant matters on hold once a year while they get involved in the annualbudget preparation process.

6 Managers short-term planning horizons would not slip below eight or ninemonths.The need for managers to think ahead each quarter (or month), whenupdating their budgets, should reduce the risk of the business being caught out byunforeseen events.

A particular benefit of rolling budgets is that the control of working capital levels(cash, short-term borrowing, debtors and creditors) should be improved bymonthly or quarterly updates, which will feed into the working capital controlmodels.

As rolling budgets are up-to-date and regularly revised, they can reduce the

element of uncertainty and guesswork that is inevitable in the budget setting process.Therefore, because they are likely to be more realistic than fixed-period budgets,rolling budgets can be a better means of motivating managers.

There are,of course,potential drawbacks.However, most of the problems that areidentified below can be overcome by managing the budgeting process efficiently andsensitively.

1 Managers may feel that the goal posts are being moved continually. This maydiscourage them from participating fully in the budgeting process.

2 Some managers may regard the rolling budget as an opportunity to manipulatetheir figures, or to continually put off the achievement of operational goals.

The revisions to budgets should feed through to (or from) the standard costing sub-system,which means that standard costs and times may be up-dated more frequently.

However, constantly changing standards could unsettle some managers. Similarly,any stock values based on standard costs may also be subject to frequent changes, but,as these would only be reflecting the current reality, this should not be seen as adisadvantage.

No organisation should need to choose between flexible, activity-based androlling budgets. All three systems are compatible with each other. In fact, the idealbudgeting system for some organisations could be a combination of all three.


Describe how rolling budgets can enable an organisation to avoid some of the

problems experienced with conventional annual budgets.

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CHAPTER SUMMARY

This chapter covers the three main alternatives to the

conventional fixed budget, i.e. flexible budgeting, activity-

based budgeting and rolling or continuous budgets.

Incremental and zero-based budgeting are mentioned, but

not developed, as they are not in the ICSA syllabus. Detailed

coverage concerns:

variances, both adverse and favourable;

reasons for variances;

using sales volumes to flex budgets;

using flexible budgets for control purposes;

converting multi-product output figures into standard

hours;

the format for flexible budget reports;

a discussion of the linear assumption used for flexible

budgeting;

using flexible budgets for planning;

using flexible budgets for performance appraisal;

the mechanics of activity-based budgeting;

the benefits of ABB to an organisation;

the problems with the conventional annual budgeting

process;

the mechanics of constructing rolling budgets;

the benefits and drawbacks of rolling/continuous

budgets;

the compatibility of flexible, activity-based and rolling

budget systems with each other.

All three budgeting systems covered in this chapter could be

the subject of written style questions in the examination, so it

is important that you are able to describe them and to explain

what it is that they are intended to achieve. Examination

candidates will be expected to be able to prepare a flexible

budgeting operating statement in a marginal costing format.

You could also be called upon to construct a flexible budget

in a standard costing context in the examination. This will be

covered in Chapters 14 and 15.

You could be required to construct an ABB from ABC

information, or even to combine ABB with flexible budgeting

and standard costing. Therefore, you should recognise that

all three budgeting systems described in this chapter can be

combined.

PRACTICE QUESTIONS

Section A (4 marks each)

11.1 Suggest four reasons why the actual material costs, direct labour costs and variable production overheads incurred

during a budget period may be different from those budgeted.

11.2 Explain why:

(a) the actual revenue achieved in a budget period may differ from the budgeted revenue;

(b) actual fixed costs may differ from budget.

11.3 Whenever Ltd, an engineering company, defines a standard hour as the amount of work that a skilled operative can

produce in one hour. The company employs three grades of direct labour, skilled, semi-skilled and learners. Each semi-

skilled operative is expected to produce 0.5 standard hours output per hour worked, and each learner should produce 0.25

standard hours per hour worked. The basic working week is 37 hours. Operatives can work overtime but output per overtime

hour (productivity) falls by 20 per cent.

Whenever Ltd employs 85 skilled operatives, 128 semi-skilled operatives and 44 learners.

The company makes three types of photocopier, the Basic, Domestic and High Capacity. The standard hours per unit

and the budgeted output for the next week are:

Copier Basic Domestic High Capacity

Standard hours per unit 32 18 53

Budget output for the next week (units) 120 48 27

Required

How many hours of overtime working should Whenever Ltd budget for the next week?

11.4 Briefly explain the problems with the conventional annual budgeting process.

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11.5 Joly Consulting Ltd had the following data for the month ending 30 September:

Budgeted sales 20,000 standard hours

Actual sales 16,000 standard hours

Budgeted consultant hours worked 20,000

Actual consultant hours worked 12,000

Standard contribution 10 per hour

Actual contribution 11 per hour

Budgeted fixed overhead 170,000

Actual fixed overhead 175,000

Calculate:

the original budgeted profit (loss)

the actual profit (loss)

the flexible budget profit (loss).

11.6 Suggest eight benefits to an organisation of using rolling budgets.

Section B (20 marks each)

11.7 Cordeline Ltd is a medium-sized firm that manufactures glass reinforced plastic (GRP) products, such as boat hulls,

water tanks and panels for the interior or exterior cladding of buildings. The company has one large production plant at which

all the Head Office staff are also employed, plus a number of small production units in different locations. The market for

Cordeline Ltds products is volatile and normally the company has only enough orders on hand to keep it busy for the next

month or two. The business is not seasonal.

Cordeline Ltds Chief Executive is dissatisfied with the current fixed, annual, budgeting system and is considering flexible

budgeting or rolling budgets as alternatives.

Required

As Company Secretary, write a memo to Cordeline Ltds Chief Executive that explains:

how each of the proposed budgeting systems work;

the situations for which each system is applicable;

the benefits the company could expect from adopting each budgeting system. (20 marks)

11.8 Brocken Limited produces three different vacuum cleaners. At present the company absorbs production overhead

costs by using a single rate per machine hour for machine costs and a rate per direct labour hour for the remainder. However,

the company intends to implement a system of activity-based costing.

Required

Explain to Brocken Limiteds management:

(a) How ABC can benefit the company. (6 marks)

(b) How an ABC system may be developed into activity-based budgeting. (6 marks)

(c) How ABB can benefit the company. (8 marks)

11.9 Phelan Forests Ltd produces timber for the paper industry. The companys output is measured in cubic metres of

timber. All its output is delivered to one customer, a paper mill. Phelan Forests Ltd has no stocks of felled timber as deliveries

to the paper mill are made each day. Phelan Forests Ltd pays extraction fees to the owners of the forest of 20 per cubic

metre of timber felled.

Phelan Forests Ltds budgetary control system is based upon fixed budgets, i.e. no adjustment is made for changes in the

volume of output. You have recently taken over the administration of Phelan Forests Ltd. You note that actual monthly output

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is frequently very different from the budgeted output. You are concerned to find that the companys managers pay little

attention to the variances contained in the monthly operating statement report.

The operating statement for the month of May is set out below. You have identified that those items that are marked with a

V are variable and change directly with output.

Phelan Forests Ltd Operating statement for month of May

Budget Actual Variances

Quantity produced (cubic metres) 1,000 1,150 150

Revenue 100,000 V 120,750 20,750

Costs:

Extraction fees 20,000 V 23,000 (3,000)

Wages & salaries of:

Production labour 20,000 V 24,150 (4,150)

Maintenance 2,000 1,950 50

Supervision 3,000 2,800 200

Management & administration 4,500 4,650 (150)

Total wages and salaries 29,500 33,550 (4,050)

Fuel, oil and spares for:

Saws 1,000 V 1,035 (35)

Tractors & winches 500 V 460 40

Vans & trucks 250 275 (25)

Total fuel, oil and spares 1,750 1,770 (20)

Expenses:

Production 1,250 V 1,495 (245)

Maintenance 1,500 1,550 (50)

Management & administration 2,300 2,890 (590)

Buildings 850 720 130

Total expenses 5,900 6,655 (755)

Depreciation:

Saws 400 V 460 (60)

Tractors & winches 1,500 V 1,725 (225)

Vans & trucks 2,500 2,500 0Maintenance equipment 1,300 1,300 0

Office equipment & furniture 950 950 0

Total depreciation 6,650 6,935 (285)

Total costs 63,800 71,910 (8,110)

Profit (loss) 36,200 48,840 12,640

Required

(a) Redraft the May operating statement in a marginal costing format and at the same time replace the original fixed budget

with a flexible budget. You do NOT need to include an original budget column in your revised report. (11 marks)

(b) Write a memo to G.V. Singh, Phelan Forests Ltds general manager, which sets out the problems with the original budget

report format and explains how the introduction of marginal costing combined with flexible budgeting could improve the

monthly budget report. (6 marks)

(c) You have discovered that Phelan Forests Ltds maintenance expenses are semi-variable. The output figures and

maintenance expenses for January to May are:

Month Output Maintenance expenses

m3

January 1,100 1,530

February 900 1,460

March 1,000 1,510

April 1,300 1,620

May 1,150 1,550

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Required

Use the High-Low Technique to estimate the variable maintenance expense per cubic metre of output and the fixed

maintenance expense per month. (3 marks)

11.10 Redleaf plc manufactures portable gas heaters. The company produces three models:

Model DH an indoor domestic heater

Model OH an outdoor heater for patios, etc.

Model IH an industrial heater for warehouses, etc.

Redleaf plc only makes the external casing of the heaters, as the valves, burners and other internal parts are bought in from

outside suppliers. The heater cases are made from thin sheets of steel, which are cut and shaped into panels in the Forming

Department. Panels are then passed to the Painting Department, where they are stove enamelled. Painted panels and

bought in components are converted into finished heaters in the Assembly Department. Assembled products are passed to

the Inspection Department before being stored in the Finished Goods Store.

Each Model DH contains 8 panels and 20 components.

Each Model OH contains 15 panels and 24 components.

Each Model IH contains 12 panels and 32 components.

Model DH is produced in batches of 20 units.

Models OH and IH are produced in batches of 10 units.

Budgeted output, sales, selling prices and variable costs for JulyDecember 200X

Model DH OH IH

Output and sales (units) 4,000 5,800 1,900

Selling prices (per unit) 38.50 62.00 312.00

Direct materials (per unit) 12.40 23.30 112.00

Direct labour (per unit) 6.20 12.60 31.00

Variable selling costs 10 per cent of sales 15 per cent of sales 12 per cent of sales

Budgeted overheads and cost drivers for JulyDecember 200X

Activity: Cost pool Cost driver:

Purchasing 26,500 Components used

Storing raw materials 15,800 Components used

Forming 46,900 Panels produced

Painting 24,400 Panels produced

Assembly 32,780 Batches produced

Materials handling 19,200 Batches produced

Inspection 42,350 Units produced

Storing finished goods 27,700 Units produced

Budgeted marketing and administration costs for July to December 200X are 178,000.

Required

Prepare a budgeted operating statement for July to December 200X showing:

(a) The contribution from each model (4 marks)

(b) The profit from each model after attribution of activity based costs (15 marks)

(c) The total profit after marketing and administration costs. (1 mark)

11.11

Pelykon International(PI) offers itscustomersan insurance schemethat,in return fora monthly premium, provides a maintenance

andemergency repairservice fortheirdomesticappliances andsystems.PIs customersare offered three levelsof service:

(i) 3-star service a complete service covering all appliances (e.g. washing machines, TVs and air-conditioning units) and

systems (e.g. water and sewage pipes; central heating systems; telephone and electrical cabling).

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(ii) 2-star service a service covering systems only.

(iii) 1-star service a basic contract providing emergency plumbing services only.

PI uses a flexible budgeting system, plus standard costs and variance analysis to monitor its progress.

PI commenced operations three years ago. The companys budgeted revenues and costs for the next year are:

(i) Budgeted number of customers:

Service level 3-star 2-star 1-star

Average number of customers during the next year 11,000 6,000 15,000

(ii) Standard numbers of visits per year made by service engineers to each category of customer are:


Standard number of service visits per customer p.a. 4 2 1

(iii) The standard service engineers time per visit is two hours.

(iv) Customers are invoiced on a monthly basis. Standard monthly premiums per customer are:


Standard premium per customer per month 40 25 8

(v) PI employs a single grade of service engineer. PIs service engineers are trained to undertake all types of service and

maintenance operations. The standard wage rate for service engineers is 20 per hour.

(vi) Spare parts and materials used in maintenance and repair jobs are treated as variable overheads. Standard variable

overhead costs per service engineer hour are:


Standard variable o/h cost per service engineer hour 16 10 4

(vii) Budgeted activity-based fixed costs for the year ended 31 December are:

Activity:

Marketing and sales 256,000

Contract management administering customers service contracts 448,000

Call centre providing a telesales service for marketing and sales;

receiving emergency calls from customers; instructing service engineers

to make service visits to customers 352,000

Purchasing and stores providing the materials and parts required by

service engineers 284,000

Accounting and credit control 480,000

Personnel management and staff training recruiting and training

service engineers 426,000

Transport providing and maintaining the vehicles used by service

engineers 355,000

Required

Prepare a statement that sets out the:

(a) budgeted annual contribution made by each service level. (5 marks)

(b) budgeted annual profit made by each service level, after activity-based costs. (15 marks)



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