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chapter

11

Types of budget

contents
1 2 Fixed budgets Flexible budgets 3 4 Activity-based budgeting Rolling/continuous budgets

learning outcomes
This chapter continues the syllabus sub-section entitled Medium-term planning and decisionmaking. The specic syllabus topics are Fixed budgets, exible 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 xed budgets for control purposes. Describe the reasons why actual results may vary from budgeted results. Construct a exible budget operating statement from given information. Convert multi-product output gures into standard hours. Explain the benets of using exible budgets for control and planning. Prepare an activity-based budget from given information. Explain the benets to organisations of using an ABB system. Explain the drawbacks of using xed-period budgets. Describe the mechanics of constructing rolling budgets. Explain how rolling budgets can overcome xed-period budgets problems. Describe the potential problems with rolling budgets and how these may be overcome. Recognise that exible, activity-based and rolling budget systems are compatible.

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The aims of budgeting include planning, facilitating control and providing motivation. Some of these aims may conict. Such conicts may be overcome by producing separate budgets for planning from those prepared for control purposes. For instance, CIMA Ofcial Terminology suggests that a xed budget could be used for planning and a exible budget could be used for control purposes. There are a variety of alternative approaches to budgeting. The best known are listed below.The denitions are all taken from CIMA Ofcial Terminology.
Fixed budget:A budget which is normally set prior to the start of an accounting

incremental budgeting
A method of budget setting in 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 specically justied, as though the activities to which the budget relates were being undertaken for the rst time. Without approval, the budget allowance is zero.

period, and which is not changed in response to subsequent changes in activity or costs/revenues. Fixed budgets are generally used for planning purposes. Fixed budgets suffer from a number of disadvantages if used for control.These are elaborated in section 1, below. Flexible budget A budget which, by recognising different cost behaviour patterns, is designed to change as volume of activity changes. Flexible budgets are covered in section 2 below. Activity-based budgeting (ABB): A method of budgeting based on an activity framework and utilising cost driver data in the budget-setting and variance feedback process. See section 3 below for details on ABB. 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 benecial where future costs and/or activities cannot be forecast accurately. The mechanics and benets of rolling budgets are described in Section 4 of this chapter. Incremental budgeting:A method of budget setting in 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. For example, if activity levels are expected to be unchanged the budget for the coming year is simply based on the current years budget, plus an increase or decrease to compensate for expected price changes.This method is crude and cannot be recommended, as it does not stimulate managers to continually improve efciency levels. Zero-based budgeting: A method of budgeting which requires each cost element to be specically justied, as though the activities to which the budget relates were being undertaken for the rst time. Without approval, the budget allowance is zero. Zero-based budgeting (ZBB) attempts to overcome the defects of incremental budgeting by requiring managers to obtain detailed approval for all projected expenditure. While the principle is sound the ZBB process can become over-bureaucratic, costly and time-consuming. For this reason, full ZBB systems are rare.

xed 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.

This chapter, and the syllabus, is restricted to xed, exible, rolling/continuous and activity-based budgeting systems. Incremental budgeting can scarcely be described as a system, while ZBB is not used widely enough to justify its inclusion in the syllabus.

1 Fixed budgets
Before looking at the various other types of budget we should consider why xed budgets are unsuitable for control purposes.

1.1 Variances
variance
The difference between a planned, budgeted or standard cost and the actual cost incurred. The same comparison may be made for revenues.

Chapter 3 section 5.3 explains that in budgetary control systems, actual revenues and expenditures are compared with budgeted gures to identify variances.A variance is dened as The difference between a planned, budgeted or standard cost and the actual cost incurred.The same comparison may be made for revenues (CIMA Ofcial Terminology).
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An adverse variance occurs when actual revenue is less than budget or actual cost is higher than budget, while if actual revenue is higher than budget or actual cost is below budget the difference is described as a favourable variance. Please note that in this text adverse variances in operating statements are shown in brackets.This is normal practice, and should be followed at all times in the examination.The reason is that gures in brackets are easier to see than if initials or words are used to distinguish between favourable and adverse variances. For example, 100,000F and 100,000A can look similar on an operating statement, whereas 100,000 and (100,000) are clearly different.

1.2 Reasons for variances

There are three reasons why the actual revenue achieved in a budget period may differ from the budgeted revenue.
1 The most likely is that the quantity sold may be more or less than that in the

budget.
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 variable production overheads incurred may be different from those budgeted.
1 The variances could be due to the higher, or lower, volume of sales causing the

quantities of materials, direct labour and variable production overheads consumed, to exceed, or fall below, the budget. 2 Variances could also occur due to changes in the prices paid for materials, direct labour and variable production overheads. 3 The mix of materials, or the composition of the direct labour employed, could also vary from budget. 4 A change in the efciency with which material, direct labour and variable production overheads are used could result in the quantities of these resources consumed being different from that in the budget. Sales commission is the only other common variable cost. It should only vary from budget if the sales revenue differs, or if there has been a change in the way in which the commission is calculated. Actual xed overhead costs should only differ from the budget if the actual prices of the xed overheads were different or if some of the xed overhead costs had been omitted from the budget. All variable costs will differ from the budget if the sales volume is higher or lower than the budget. If the production managements performance is assessed against a xed budget and the actual sales are higher than the budget it is likely that there will be adverse production cost variances. But these increases in the variable production costs are simply due to the actual sales volume being different from the budget, so these 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 use budgets for control purposes, then we should distinguish between controllable and non-controllable costs.Therefore, budgetary control should concentrate on controllable factors such as price, efciency and mix. However, if we compare actual costs with a xed budget, it will be difcult to isolate any variances that are due to changes in the actual prices, efciency or mix (i.e. controllable variances), as they may well be swamped by the variances due to differing sales volumes (a non-controllable variance).Therefore, xed budgets are not really effective for control purposes.

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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 xed, 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 xed 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 Sales quantity Revenue Material costs Contribution Fixed cost Prot 10,000,000 500,000 200,000 300,000 250,000 50,000 Actual 12,000,000 600,000 240,000 360,000 250,000 110,000 Variance 2,000,000 100,000 (40,000) 60,000 0 60,000 Variance as per cent of budget 20 per cent 20 per cent (20 per cent) 20 per cent 0 120 per cent

It appears from the above statement that the sales manager has contributed an extra 100,000 towards prots, while the production manager has depressed prots 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 prots.

test your knowledge 11.1

Why is xed budgeting not very effective for control purposes?

exible budget
A budget which, by recognising different cost behaviour patterns, is designed to change as volume of activity changes.

2 Flexible budgets
The ineffectiveness of xed budgets for control purposes can be dealt with by using a exible budget instead. A exible budget is designed to change as a businesss activity increases or decreases.

2.1 Using sales volume to ex a budget

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

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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 xed, 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 xed costs were exactly as budgeted. Required Prepare a exible 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 Sales quantity Revenue Material costs Contribution Fixed cost Prot 10,000,000 500,000 200,000 300,000 250,000 50,000 Flexed budget 12,000,000 600,000 240,000 360,000 250,000 110,000 Actual 12,000,000 600,000 240,000 360,000 250,000 110,000 Variance 0 0 0 0 0 0

The sales volume is 20 per cent higher so we ex the original budget so that the budgeted revenue, material cost and contribution are all 20 per cent higher. By exing the budget, the above operating statement eliminates the volume effect entirely and shows that there were no variances due to prices or efciency 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 prot and the exed budget prot, i.e. 110,000 50,000 60,000 favourable volume variance.

2.2 Using exible budgets for control purposes

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

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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 xed, and were budgeted at 250,000 for the year. The exible budget operating statement is set out below. Operating statement for the year ending XX/XX/XX Original budget Sales quantity Flexed budget Actual 12,000,000 550,000 230,000 320,000 240,000 80,000 Variance 0 (50,000) 10,000 (40,000) 10,000 (30,000) 60,000

10,000,000 12,000,000 Revenue 500,000 600,000 Material costs 200,000 240,000 Contribution 300,000 360,000 Fixed overheads 250,000 250,000 Prot 50,000 110,000 Sales volume variance (Original budget prot exed budget prot) 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 exible budget identies 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. Comparison with the exible budget highlights the favourable material cost variance achieved.

While most examples in this text will show exible budgets being used for control in a manufacturing context, the technique is just as useful for extractive industries and for any service industries that have signicant variable costs.

2.3 Standard hours

Budgeted and actual sales volumes can be measured in units, tonnes or litres if there is a single product. It is more difcult to nd a single measure for output if there is more than one product. One solution is to use the standard time required to achieve the particular level of output. As you would expect, standard time is measured in standard hours and minutes. CIMA Ofcial Terminology denes a standard hour or minute as The amount of work achievable, at standard efciency levels, in an hour or minute. The standard time may relate to machine hours if all output goes through the same, or similar, machines. Standard time can also relate to process hours, if all output goes through the same process. However, in most cases standard time relates to direct labour hours, whether for a manufactured product or for a service.

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worked example 11.4

Crewed Fabrications manufactures breglass canoes. The manufacturing process is very labour-intensive. Crewed Fabrications make three products, two-seat, four-seat and eight-seat canoes. It takes ve 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: Standard direct hours per canoe Budgeted output for the month Actual output in the month Required Compare the budgeted and actual standard hours produced in the last month. Answer Type of canoe: 2 seats 4 seats 8 100 50 800 400 (400) 8 seats 14 100 50 1,400 700 (700) Total n.a. 300 300 2,700 2,100 (600) 2 seats 5 100 200 4 seats 8 100 50 8 seats 14 100 50 Total n.a. 300 300

Standard direct hours per canoe 5 Budgeted output for the month (units) 100 Actual output in the month (units) 200 Budgeted output for the month (standard hours) 500 Actual output in the month (standard hours) 1,000 Variance (standard hours) 500

Most costs vary with input-based activity levels, e.g. direct wages vary with direct hours worked. However, the exible budget allowance should be based on output measures, such as tonnes delivered or standard hours produced.This will highlight the efciency with which resources are used. So, we should identify those costs and revenues that vary with output and amend the budget to reect actual activity, before comparing it with actual costs and revenues.

2.4 Format for exible budget operating statements

Flexible budgeting can be used in both marginal and absorption costing systems. In an absorption costing system the xed costs are also exed to match output. This approach is misleading as it implies that xed costs are variable, and so requires a volume variance to be calculated if any over- or under-spends are to be isolated. Many managers nd exed absorption costing budgets confusing. If you prepare a exible budget in the examination it should always have a marginal costing format.

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worked example 11.5

Salamander Lamps Ltd make a single type of garden oodlight. 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 signicant. Budget Units sold Sales revenue Costs: Materials Labour Variable overhead Production overheads Selling overheads Administration Total costs: Prot (loss) Required Prepare a revised operating statement in a marginal costing format that includes a exible budget. Answer Flex the budgeted sales, variable costs and contribution by multiplying the original budget gures 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. Units sold Sales revenue Variable costs: Materials Labour Variable overhead Total variable cost Contribution Fixed costs: Production overheads Selling overheads Administration Total xed costs Prot (loss) Sales volume variance Original Budget 10,000 250,000 45,000 60,000 30,000 135,000 115,000 Flexed budget 11,000 275,000 49,500 66,000 33,000 148,500 126,500 Actual 11,000 255,000 48,600 71,400 40,000 160,000 95,000 Variances (20,000) 900 (5,400) (7,000) (11,500) (31,500) (3,000) 2,000 (1,000) (2,000) (33,500) 11,500 10,000 250,000 45,000 60,000 30,000 35,000 15,000 20,000 205,000 45,000 Actual 11,000 255,000 48,600 71,400 40,000 38,000 13,000 21,000 232,000 23,000 Variances 1,000 5,000 (3,600) (11,400) (10,000) (3,000) 2,000 (1,000) (27,000) (22,000)

35,000 35,000 38,000 15,000 15,000 13,000 20,000 20,000 21,000 70,000 70,000 72,000 45,000 56,500 23,000 Flexed budget prot less original budget prot

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, learning effects can affect labour costs and some xed costs may, in fact, be stepped costs. It may be possible to construct appropriate cost and revenue formulae to deal with this problem. For instance, we could use
Material costs per unit which decrease each time the volume exceeds the bulk

discount points.
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Material costs per unit, for scarce materials, which increase if the quantity

required exceeds the quantities available from lower cost suppliers. Labour costs per unit which decrease as cumulative output increases, due to the learning effect. Stepped supervision costs. However, all calculation questions in the examination will be based on the linear assumption for revenue, variable costs and activity based costs. Questions will use a xed cost assumption for space costs and non-activity based overheads, unless distinct steps in these costs are necessary to t the facts of the question.To recap:
For all revenue, or variable costs or activity-based costs, the budgeted revenues and

costs PER UNIT will be the same, irrespective of the volume change.
For those space costs and overheads that are not activity-based, the budgeted xed

cost gure will remain the same, whatever the volume, unless distinct steps are more logical.

2.6 Flexible budgets for planning

Flexible budgeting can be used at the budget planning stage to test the effects of alternative 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 prot 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 Sales revenue Variable costs: Materials Labour Variable overhead Total variable cost Contribution Fixed costs: Production overheads Selling overheads Administration Total xed costs Prot (loss) 100,000 500,000 50,000 100,000 20,000 170,000 330,000 150,000 80,000 70,000 300,000 30,000

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theory into practice 11.1 continued

Answer Angouleme Ltd Budget comparisons for the coming year Volume assumption Standard hours sold Sales revenue Variable costs: Materials Labour Variable overhead Total variable cost Contribution Fixed overhead: Production overheads Selling overheads Administration Total xed costs Prot (loss) Sales volume variance Original budget 100,000 500,000 50,000 100,000 20,000 170,000 330,000 150,000 80,000 70,000 300,000 30,000 0 90 per cent of budget 90,000 450,000 45,000 90,000 18,000 153,000 297,000 150,000 80,000 70,000 300,000 (3,000) (33,000) 80 per cent of budget 80,000 400,000 40,000 80,000 16,000 136,000 264,000 150,000 80,000 70,000 300,000 (36,000) (66,000) 110 per cent of budget 110,000 550,000 55,000 110,000 22,000 187,000 363,000 150,000 80,000 70,000 300,000 63,000 33,000

2.7 Flexible budgets for performance appraisal

Flexible budgets can also be used as a basis for performance appraisal. However, as exible budget calculations are approximations they should be used with care when evaluating managerial performance. For instance, it is not only the number of items or 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 or products can also affect cost performance.

test your knowledge 11.2

Explain why the linear assumption used for exible budgeting may be a simplication of the real movement in costs as volume changes.

3 Activity-based budgeting
Activity-based costing (ABC) can be used to produce more useful overhead budgets. Activity budgets can be built up by multiplying the planned volumes of each product by the planned quantity of each cost driver consumed and the expected cost per unit of cost driver. This is known as Activity-Based Budgeting (ABB). Activity-based budgets can be used for planning, and control, by combining exible budgeting principles with activity-based costing. However, it is critical to identify reliable serviceunits (or cost drivers), otherwise you may alter the budget by 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 cost

drivers; budgets for the provision of activities. Once the standard costs per unit of cost driver and the standard consumption of cost drivers per unit of each product have been established it is possible to:
translate the production or sales budgets for each product into quantities of cost

drivers required;
translate the budgeted quantities of each cost driver required into nancial

budgets 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 efciency 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 be compared with the budgeted gures to encourage reductions in the activities costs.

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 Budgeted output in the coming year (units) Standard batch sizes (units) Standard materials movements per batch 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 gures for the materials handling cost pool and the number of materials movements as your basis. (b) Suggest ve 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 gures, Cost pool quantity of cost driver 75,000 15,000 5 per materials movement. HP100 3,000 15 5 HP200 8,000 20 6 LP30 2,500 5 13 LP60 4,800 15 8

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theory into practice 11.2 continued

Product Budgeted output in the coming year (units) Standard batch sizes (units) Budgeted batches Standard materials movements per batch Budgeted materials movements 5 Budgeted materials handling cost pool () Standard materials movements per batch 5 Standard handling cost per unit HP100 3,000 15 200 5 1,000 5 25 HP200 8,000 20 400 6 2,400 6 30 LP30 2,500 5 500 13 6,500 13 65 LP60 4,800 15 320 8 2,560 8 40 Total

12,460 62,300

(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 efciency with which the materials handling activity is carried out may improve or deteriorate.

3.2 The benets of ABB

The benets 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 of their consumption of overhead resources. 3 Efciency of use should be enhanced because each service consumed will attract a consumption-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 benet of ABB is the establishment of explicit, but linked, responsibilities for the management of services consumption and the management of services provision. Therefore, a continuous improvement mentality can be instilled into the providers and users of overhead activities.

test your knowledge 11.3

What are the benets to an organisation of converting from an absorption costing budgeting system to ABB?

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 benecial where future costs and/or activities cannot be forecast accurately.

4 Rolling/continuous budgets
The conventional budgeting practice is to prepare an annual budget well in advance, so that budget gures 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 or September if the budget for the year commencing 1 January is to be ready for release in early December.

4.1 Problems with the conventional annual budgeting process

There are a number of problems with the conventional annual budgeting process
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1 A budget, for the year beginning 1 January, which is issued to managers during December, 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 due to out of date budget assumptions, unless the business and its operating environment are extremely stable. 2 This obsolescence factor is likely to increase as the budget year progresses, until by the last month of the budget year (month 12) the budget may well be useless for control purposes it will simply have historical signicance. 3 In some organisations, particularly in the public sector, the budget is not just part of a control mechanism, it is a means of allocating funds to activities. One of the peculiar features of this approach is that budget surpluses cannot be carried forward into the next budget year.Therefore, any money budgeted but not spent iswasted as far as the manager of an activity or department is concerned.And, where incremental budgeting is in place any money not spent in this year will result in a lower budget next year. Consequently, there may be a bout of panic buying just before the year-end, rstly to use up allocated funds and secondly so as to provide a higher base for next years budget allocations.This can result in normal value for money judgements being suspended, and therefore, a waste of resources. 4 The annual budgeting cycle is designed to t in with the external nancial reporting timetable, not with the reality of the business cycle. The agricultural year, with its seasonal pattern may be appropriate for those businesses that have distinct seasonal uctuations in sales, but it is not relevant to many other businesses such as aircraft manufacture, civil engineering, oil, pharmaceuticals and chemicals. 5 The once a year blitz involved in preparing the annual budget gets in the way of normal management activity and, because managers may have forgotten what the budgeting processes and assumptions were in the previous year, re-learning may be 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 planning horizons 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 may only be looking one or two months ahead. While exible budgets will deal with any budget obsolescence caused by actual volumes being different from the budget prediction, the other problems with annual budgets will remain. One solution to the problem is to institute a rolling (or continuous) 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 annual budget is regularly revised by discarding the segment relating to the one or three-month period that has just elapsed and adding on a new segment to the far end of the budget.The new twelvemonth budget will then be revised to reect 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 gures are used for the subsequent nine months. Preparing rolling budgets can become time-consuming and expensive if the process is badly managed or if it is difcult to obtain the necessary data. However, spreadsheet modelling combined with a nancial/operational database should minimise this problem.

4.3 The benets and drawbacks of rolling/continuous budgeting

As the CIMA denition at the start of this chapter states, rolling budgets are particularly benecial where future costs and/or activities cannot be forecast accurately.
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Rolling budgets are useful for coping with ination, as well as being valuable for rapidly developing businesses and those rms that are committed to a policy of continuous improvement. Rolling budgets are perfectly compatible with exible and activity-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 being applied. 2 The budget is unlikely to become obsolete by the second or third month of the rst quarter. 3 A rolling budget, which is continuously updated, will do away with the year-end buying spree intended to mop up surplus budget funds, because the year-end will never be reached. Therefore, funds should be spent more wisely, and only when necessary. 4 By doing away with the annual budgeting cycle, a rolling budget reinforces the reality that most commercial activity is a continuous process that does not have pauses in its activity (unlike education for example). 5 Managers should become more adept at budgeting because they would be continually 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 putting important matters on hold once a year while they get involved in the annual budget preparation process. 6 Managers short-term planning horizons would not slip below eight or nine months. The need for managers to think ahead each quarter (or month), when updating their budgets, should reduce the risk of the business being caught out by unforeseen events. A particular benet of rolling budgets is that the control of working capital levels (cash, short-term borrowing, debtors and creditors) should be improved by monthly or quarterly updates, which will feed into the working capital control models. 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 xed-period budgets, rolling budgets can be a better means of motivating managers. There are, of course, potential drawbacks. However, most of the problems that are identied below can be overcome by managing the budgeting process efciently and sensitively. 1 Managers may feel that the goal posts are being moved continually. This may discourage them from participating fully in the budgeting process. 2 Some managers may regard the rolling budget as an opportunity to manipulate their gures, or to continually put off the achievement of operational goals. The revisions to budgets should feed through to (or from) the standard costing subsystem, 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 reecting the current reality, this should not be seen as a disadvantage. No organisation should need to choose between exible, activity-based and rolling budgets. All three systems are compatible with each other. In fact, the ideal budgeting system for some organisations could be a combination of all three.

test your knowledge 11.4

Describe how rolling budgets can enable an organisation to avoid some of the problems experienced with conventional annual budgets. www.icsastudent.org/support

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CHAPTER SUMMARY
This chapter covers the three main alternatives to the conventional xed budget, i.e. exible budgeting, activitybased 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:

the mechanics of constructing rolling budgets; the benets and drawbacks of rolling/continuous
budgets;

the compatibility of exible, 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 exible budgeting operating statement in a marginal costing format. You could also be called upon to construct a exible 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 exible budgeting and standard costing. Therefore, you should recognise that all three budgeting systems described in this chapter can be combined.

variances, both adverse and favourable;

reasons for variances; using sales volumes to ex budgets; using exible budgets for control purposes; converting multi-product output gures into standard hours;

the format for exible budget reports; a discussion of the linear assumption used for exible
budgeting;

using exible budgets for planning; using exible budgets for performance appraisal; the mechanics of activity-based budgeting; the benets of ABB to an organisation; the problems with the conventional annual budgeting process;

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 xed costs may differ from budget. 11.3 Whenever Ltd, an engineering company, denes 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 semiskilled 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 Standard hours per unit Budget output for the next week (units) Basic 32 120 Domestic 18 48 High Capacity 53 27

Required How many hours of overtime working should Whenever Ltd budget for the next week? 11.4 Briey explain the problems with the conventional annual budgeting process. www.icsastudent.org/support

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11 TYPES OF BUDGET 11.5 Joly Consulting Ltd had the following data for the month ending 30 September: Budgeted sales Actual sales Budgeted consultant hours worked Actual consultant hours worked Standard contribution Actual contribution Budgeted xed overhead Actual xed overhead Calculate: 20,000 standard hours 16,000 standard hours 20,000 12,000 10 per hour 11 per hour 170,000 175,000

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the original budgeted prot (loss) the actual prot (loss) the exible budget prot (loss).
11.6 Suggest eight benets to an organisation of using rolling budgets. Section B (20 marks each) 11.7 Cordeline Ltd is a medium-sized rm 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 Ofce 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 dissatised with the current xed, annual, budgeting system and is considering exible 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 benets 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 benet the company. (b) How an ABC system may be developed into activity-based budgeting. (c) How ABB can benet the company. (6 marks) (6 marks) (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 xed 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 nd 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 identied 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 Quantity produced (cubic metres) Revenue Costs: Extraction fees Wages & salaries of: Production labour Maintenance Supervision Management & administration Total wages and salaries Fuel, oil and spares for: Saws Tractors & winches Vans & trucks Total fuel, oil and spares Expenses: Production Maintenance Management & administration Buildings Total expenses Depreciation: Saws Tractors & winches Vans & trucks Maintenance equipment Ofce equipment & furniture Total depreciation Total costs Prot (loss) Budget 1,000 100,000 20,000 20,000 2,000 3,000 4,500 29,500 1,000 500 250 1,750 1,250 1,500 2,300 850 5,900 400 1,500 2,500 1,300 950 6,650 63,800 36,200 Actual 1,150 120,750 23,000 24,150 1,950 2,800 4,650 33,550 1,035 460 275 1,770 1,495 1,550 2,890 720 6,655 460 1,725 2,500 1,300 950 6,935 71,910 48,840 Variances 150 20,750 (3,000) (4,150) 50 200 (150) (4,050) (35) 40 (25) (20) (245) (50) (590) 130 (755) (60) (225) 0 0 0 (285) (8,110) 12,640

V V V

V V

V V

Required (a) Redraft the May operating statement in a marginal costing format and at the same time replace the original xed budget with a exible 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 exible budgeting could improve the monthly budget report. maintenance expenses for January to May are: Month January February March April May Output m3 1,100 900 1,000 1,300 1,150 Maintenance expenses 1,530 1,460 1,510 1,620 1,550 (6 marks) (c) You have discovered that Phelan Forests Ltds maintenance expenses are semi-variable. The output gures and

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11 TYPES OF BUDGET Required Use the High-Low Technique to estimate the variable maintenance expense per cubic metre of output and the xed maintenance expense per month. 11.10 Redleaf plc manufactures portable gas heaters. The company produces three models:

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(3 marks)

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 nished 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 Output and sales (units) Selling prices (per unit) Direct materials (per unit) Direct labour (per unit) Variable selling costs DH 4,000 38.50 12.40 6.20 10 per cent of sales OH 5,800 62.00 23.30 12.60 15 per cent of sales IH 1,900 312.00 112.00 31.00 12 per cent of sales

Budgeted overheads and cost drivers for JulyDecember 200X Activity: Purchasing Storing raw materials Forming Painting Assembly Materials handling Inspection Storing nished goods Cost pool 26,500 15,800 46,900 24,400 32,780 19,200 42,350 27,700 Cost driver: Components used Components used Panels produced Panels produced Batches produced Batches produced Units produced 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 (b) The prot from each model after attribution of activity based costs (c) The total prot after marketing and administration costs. 11.11 Pelykon International (PI) offers its customers an insurance scheme that, in return for a monthly premium, provides a maintenance and emergency repair service for their domestic appliances and systems. PIs customers are offered three levels of 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). www.icsastudent.org/support (4 marks) (15 marks) (1 mark)

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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 exible 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 Average number of customers during the next year 3-star 2-star 1-star 15,000

11,000 6,000

(ii) Standard numbers of visits per year made by service engineers to each category of customer are: Service level Standard number of service visits per customer p.a. 3-star 4 2-star 2 1-star 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: Service level Standard premium per customer per month 3-star 40 2-star 25 1-star 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: Service level Standard variable o/h cost per service engineer hour 3-star 16 2-star 10 1-star 4

(vii) Budgeted activity-based xed costs for the year ended 31 December are: Activity: Marketing and sales Contract management administering customers service contracts Call centre providing a telesales service for marketing and sales; receiving emergency calls from customers; instructing service engineers to make service visits to customers Purchasing and stores providing the materials and parts required by service engineers Accounting and credit control Personnel management and staff training recruiting and training service engineers Transport providing and maintaining the vehicles used by service engineers Required Prepare a statement that sets out the: (a) budgeted annual contribution made by each service level. (b) budgeted annual prot made by each service level, after activity-based costs. (5 marks) (15 marks) 256,000 448,000

352,000 284,000 480,000 426,000 355,000

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