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Cost and Management Accounting

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Cost & Management Accounting (MGT-402)
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LESSON# 40
FLEXIBLE & ZERO BASE BUDGETING
The Flexible Budget is designed to change in accordance with the level of activity attained. Thus,
when a budget is prepared in such a manner that the budgeted cost for any level of activity is
available, it is termed as flexible budget. Such a budget is prepared after considering the fixed and
variable elements of cost and the changes that may be expected for each item at various levels of
operations. Flexible budgeting is desirable in the following cases:
Where, because of the nature of business, sales are unpredictable, e.g. in luxury or semi-luxury
trades.
Where the venture is a new and, therefore, it is difficult to foresee the demand e.g., novelties
and fashion products.
Where business is subject to the vagaries of nature, such as soft drinks,
Where progress depends on adequate supply of labor and the business is in an area which
suffering forms shortage of labor.
Controlling ratios
Budget is a part of the planning process. After the various budgets, including the master budget,
have been prepared, you may like to compare actual performance with the budget performance.
This can be done by using three important ratios as shown on the next page.
Control Ratios
Activity Ratio
Capacity Ratio
Efficiency Ratio
The above ratios are expressed in terms of percentages, if the ratio works out to 100 per cent or
more, the trend is taken as favorable, If the ratio is less than 100 per cent, the indication is taken
as unfavorable. We shall discuss these ratios in some detail.
Activity Ratio:
Activity Ratio is a measure of the level of activity attained over a period of time. It is obtained by
expressing the number of standard hours equivalent to the work produced as a percentage of the
budgeted hours.
Activity Ratio =
Standard hours for actual production
x 100
Budgeted hours
Capacity Ratio:
This ratio indicates whether and to what extent budgeted hours of activity are actually utilized. It
shows the relationship between the actual number of working hours and the maximum possible
number of working hours in a budget period.
Capacity Ratio =
Actual hours worked
x 100
Budgeted hours
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Efficiency Ratio:
This ratio indicates the degree of efficiency attained in production. It is obtain by expressing the
standard hours equivalent to the work produced as a percentage of the actual hours spent in
producing that work
Efficiency Ratio =
Standard hours for actual production
x 100
Actual hours worked
Activity
Calculate: Efficiency, Activity and Capacity ratios and comment on the results obtained for a
factory which produces two units of a commodity in one standard hour. Actual production during
a particular- year is 34,000 units and the budgeted production for the year is 40,000 units. Actual
hours operated are 16,000 (Some clues have been provided).
Two units are produced in one standard hour. Hence, for actual production of 34,000 units,
standard hours required will be 17,000 (i.e. 34,000/2). For budgeted production of 40,000 units,
budgeted hours will be 20.000
(i.e. 40,000/ 2).
Performance budgeting
As explained in the preceding pages, budgeting is nothing but the technique of expressing, largely
in financial terms, the management's plans for operating and financing the enterprise during
specific periods of time- Any system of budgeting, in order to be successful, must provide for
performance appraisal, as well as follow up measures.
The traditional (also known as line-item or object-account) budget in government enumerates
estimated expenditures by type (and quantity) for a specified period of time, usually one year, the
expenditure is classified by object; the personnel are listed by type of position; the budget is
divided into sections according to organizational units, departments, sections; and the types of
expenditure are listed by category. The primary purpose of traditional budget particularly in
government administration is to ensure financial control and meet the requirements of legal
accountability, that is, to ensure that appropriation. Sanction or allotment limits for different items
are not exceeded- 11 thus emphasize only the financial aspects. The expenditures are not related to
the intended or planned outputs (or achievements). The necessity for finking the expenditures (or
inputs in financial terms) to outputs (in physical terms), facilitating the evaluation of outcomes (or
results of activities) cannot be over emphasized.
Performance budgeting (or programme budgeting) has been designed to correct the shortcomings
of traditional budgeting by emphasizing management considerations/ approaches. Both the
financial and physical aspects are incorporated into the budget- A performance budget presents the
operations of an organization in terms of functions, programmes, activities, and projects.
In performance budgeting, Precise detail of job to be performed or services to be rendered is done.
Secondly, the budget is prepared in terms of functional categories and their sub-division into
programmes, activities, and projects. Thirdly, the budget becomes a comprehensive document.
Since the financial and physical results are interwoven, it facilitates management control.
The main objectives of PB are; (1) to coordinate the physical and financial aspects; (ii) to improve
the budget formulation, review and decision-making at all levels of management; (iii) to facilitate
better appreciation and review by controlling.
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Authorities (legislature, Board of Trustees or Governors, etc.) as the presentation is more
purposeful and intelligible; (iv) to make more effective performance audit possible; and (v) to
measure progress towards long-term objectives which are envisaged in a development plan.
Performance budgeting involves evaluation of the performance of the organisation in the context
of both specific, as well as, overall objectives of the organisation. It presupposes a crystal clear
perception of organizational objectives in general, and short-term business objectives as stipulated
in the budget, in particular by each employee of the organisation, irrespective of his level. It, thus,
provides a definite direction to each employee and also a control mechanism to higher
management.
Performance budgeting requires preparation of periodic performance reports. Such reports
compare budget and actual data, and show variances. Their preparation is greatly facilitated if the
authority and responsibility for the incidence of each cost element is clearly defined within the
firm's organizational structure- In addition, the accounting system should be sufficiently detailed
and coordinated to provide necessary data for reports designed for the particular use of the
individuals or cost centers having primary responsibility for specific cost.
The responsibility for preparing the performance budget of each department lies on the respective
Department Head. Each Department Head will be supplied with a copy of the section of the
master budget appropriate to his sphere. For example, the chief buyer will be supplied with the
copy of the materials purchase budget so that he may arrange for purchase of necessary materials-
Periodic reports from various sections of a department will be received by the departmental head
who will submit a summary report about his department to the budget committee. The report may
be daily, weekly or monthly, depending upon the size of business and the budget period. These
reports will be in the form of comparison of budgeted and actual figures, both periodic and
cumulative. The purpose of preparing these reports is to promptly inform about the deviations in
actual and budgeted activity to the person who has the necessary authority and responsibility to
take necessary action to correct the deviations from the budget,
Zero base budgeting
Earlier we have explained the formulation or different types of budgets. If the approach adopted in
the formulation and preparation of budgets is based on current level of operations or activities,
including current level of expenditure and revenue, such budgeting is known as traditional
budgeting. This type of budgeting process generally assumes that the allocation of financial
resources in the past was correct and will continue to hold good for the future as well. In most
cases, an addition is made to the current figures of costs to allow for expected (or even
unexpected) increases. Consequently, the budget generally takes an upward direction year after
year, in spite of generally declining efficiency. Such a system of budgeting cannot be expected to
promote operational efficiency. It may, on the other hand, create several problems for top
management. Some of these problems are:
Programmes and activities involving wasteful expenditure are not identified, resulting in
avoidable financial and other costs.
Inefficiencies of a prior year are carried forward in determining subsequent years' levels of
performance.
Managers are not encouraged to identify and evaluate alternate means of accomplishing the
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same objective.
Decision-making is irrational in the absence of rigorous analysis of all proposed costs and
benefits.
Key problems and decision areas are not highlighted. Thus, no priorities are established
throughout the organization.
Managers tend to inflate their budget requests resulting in more demand for funds than their
availability these results in recycling the entire budgeting process.
Thus, the traditional budgeting technique may be quite meaningless in the present context when
management must review or re-evaluate every task with a view to better project which have a
positive cost-benefit analysis or which are capable of meeting the objective of the organization.
The above analysis shows that zero base budgeting is in a way an extension of the method of cost-
benefit analysis to the area of the corporate building.
Advantages of Zero Base Budgeting
Let us summaries the advantages of zero base budgeting:
It provides the organization with a systematic way to evaluate different operations and
programmes undertaken. It enables management to allocate resources according to the priority
of the programmes.
It ensures that each and every programme undertaken by management is really essential for the
organization, and is being performed in the best possible way.
It enables the management to approve departmental budgets on the basis of cost-benefit
analysis. No arbitrary cuts or increases in budget estimates are made.
It links budgets with the corporate objectives. Nothing will be allowed simply because it was
being done in the past. An activity may be shelved it does not help in achieving the goals of the
enterprises.
It helps in identifying areas of wasteful expenditure and, desired, it can also be used for
suggesting alternative courses of action.
It facilitates the introduction and- implement of the system of management by objectives. Thus, it
can be used not only for the objective of traditional budgeting, but also for a variety of other
purposes.
It is contended that zero base budgeting it happens only in the (initial stages when to be identified
and decision packages have to be developed or completed. Once this is done, and the
methodology is "clear, zero base budgeting is likely to take less time than the traditional budgeting.
In any case, till such time the organisation is properly acclimatized to the technique of zero base
budgeting, it may be done in a way that all responsibility centers are covered at least once in three
or four years.
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Zero base budgeting as a concept has become quite popular these days. The technique was first
_used by the U.S. Department of Agriculture in 1962. Texas instruments, a multinational company,
pioneered its use in the private sector. Today a number of major companies such as Zerox, BASF,
International Harvester and Eastern Airlines in the United State are using the system. Some
departments of government of India have recently introduced zero bases budgeting with a view to
make the system of control more effective.
The responsibility for preparing the budget rests on the Budget Controller, who is assisted in his
work by a Budget Committee. The Budget Committee may consist of heads of various
departments, viz., Sales, Production, and Personnel. Purchase, Finance etc. Each head of the
department is made responsible for preparing and executing the budget of his department. In a
business organization, preparation of any budget is preceded by a sales forecast. Production budget
is prepared after considering the forecasts embodied in the sales budget and the available
productive capacity etc. Production budget includes the preparation of various cost budgets
associated with production process. Budgets pertaining to different functions or units are then
combined and coordinated into one Master Budget.
The budgets may be revised from time to time if the changed conditions or new developments so
warrant. A budget may be fixed or flexible. A fixed budget is based on fixed volume of activity. If
actual capacity utilization is likely to vary from period to period, flexible budgets are more
desirable. A flexible budget is thus prepared for changing levels of activity. It considers fixed and
variable costs separately and is therefore more useful to a business where the level of activity
cannot be exactly predicted.
In a system of budgetary control, control ratios may be computed and used in order to compare
the actual performance with the budgeted performance. These ratios are: activity ratio, capacity
ratio and efficiency ratio. In case the ratio is hundred percent or more, it is considered favorable. If
it is less than hundred per cent, it is taken as unfavorable.
The traditional budgeting technique which takes the current level of operations as the basis for
estimating the future level of operations is slowly going out of date. It is being increasingly realized
that the traditional technique has serious shortcomings in view of the constantly changing
conditions of today; the management is expected to review and re-evaluate the tasks in view of the
increasing pressures of environment. The concept of zero base budgeting is being considered as a
suitable alternative to replacing the traditional method. Zero base Budgeting technique suggests
that an organization should not only make decisions about the proposed new programmes, but
should also, from time to time, review the appropriateness of the existing.
The concept of Zero base Budgeting has been accepted for adoption in the departments of the
Central Government, and some State Governments.
Activity
ABC Co. wishes to arrange over draft facilities with its bankers during the period April to June
when it will be manufacturing mostly for stock. Prepare a Cash Budget including the extent of
bank facilities the company will require at the end of each month for the above period from the
following data.
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Sales
Purchases
Wages
Rs.
Rs.
Rs.
February
18,000
12,480
1,200
March
19,200
14,400
1,400
April
10,800
24,300
1,100
May
17,400
24,600
1,000
June
12,500
26,800
1,500
a) 40% is cash sale.
b) 50 per cent of credit sales is realized in the month following the sale and the remaining 50
per cent in the second month following. Creditors are paid in the month following (he
month of purchase.
c) Cash at bank on the 1st April (estimated) is Rs. 25, 00.
Activity
Jammu Manufacturing Company Ltd. is to start production on 1st January, 19x3- The prime cost
of a unit is expected to be Rs. 40 out of which Rs. 16 is for materials and Rs. 24 for labour. In
addition, variable expenses per unit are expected to be Rs. 8, and fixed expenses per month Rs,
30,000. Payment for materials is to be made in the month following the purchase. One-third of
sales will be for cash and the rest on credit for settlement in the following month. Expenses are
payable in the month in which they are incurred. The selling price is fixed at Rs. 80 per unit the
number of units manufactured and sold is expected to be as under:
January
900
April
2,000
February
1,200
May
2,100
March
1,800
June
2,400
Draw a cash budget showing requirements of cash from month to month.
Activity
The Sudershan Chemicals Ltd., operates a system of flexible budgetary control.
A flexible budget is required to show levels of activity at 70%, 80% and 90%. The
following is a summary of the relevant information:
a)
Sales  based  on  normal  level  of  activity  of  70%  (3,50,000)  units  at
Rs. 200 each. If output is increased to 80% and 90%, selling prices are to be reduced by
2.5% and 5% of the original selling price respectively in Order to reach a wider market.
b)
Variable costs are Rs. 100 per unit (70% is the cost of raw material). In case output
reaches 80% level of activity or above the effective purchase of raw material will be
reduced by 5%.
c)
Variable overheads: Salesman's commission is 2% of sale value.
d)
Semi-variable overheads (total) at 3,50,000 units are Rs. 1,20,00,000. They are expected
to increase by 5% if output reaches a level of activity of 80% and by a further 10% if it
reaches the 90% level,
e)
Total fixed overheads are Rs. 2,00,000, which is likely to remain unchanged up to 100%
capacity.
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Activity
Calculate: (a) Efficiency Ratio (b) Activity Ratio (a) Capacity Ratio from the following figures:
Budgeted production
880 units
Standard hours per unit
10
Actual production
750 units
Actual working hours
6,000
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Table of Contents:
  1. COST CLASSIFICATION AND COST BEHAVIOR INTRODUCTION:COST CLASSIFICATION,
  2. IMPORTANT TERMINOLOGIES:Cost Center, Profit Centre, Differential Cost or Incremental cost
  3. FINANCIAL STATEMENTS:Inventory, Direct Material Consumed, Total Factory Cost
  4. FINANCIAL STATEMENTS:Adjustment in the Entire Production, Adjustment in the Income Statement
  5. PROBLEMS IN PREPARATION OF FINANCIAL STATEMENTS:Gross Profit Margin Rate, Net Profit Ratio
  6. MORE ABOUT PREPARATION OF FINANCIAL STATEMENTS:Conversion Cost
  7. MATERIAL:Inventory, Perpetual Inventory System, Weighted Average Method (W.Avg)
  8. CONTROL OVER MATERIAL:Order Level, Maximum Stock Level, Danger Level
  9. ECONOMIC ORDERING QUANTITY:EOQ Graph, PROBLEMS
  10. ACCOUNTING FOR LOSSES:Spoiled output, Accounting treatment, Inventory Turnover Ratio
  11. LABOR:Direct Labor Cost, Mechanical Methods, MAKING PAYMENTS TO EMPLOYEES
  12. PAYROLL AND INCENTIVES:Systems of Wages, Premium Plans
  13. PIECE RATE BASE PREMIUM PLANS:Suitability of Piece Rate System, GROUP BONUS SYSTEMS
  14. LABOR TURNOVER AND LABOR EFFICIENCY RATIOS & FACTORY OVERHEAD COST
  15. ALLOCATION AND APPORTIONMENT OF FOH COST
  16. FACTORY OVERHEAD COST:Marketing, Research and development
  17. FACTORY OVERHEAD COST:Spending Variance, Capacity/Volume Variance
  18. JOB ORDER COSTING SYSTEM:Direct Materials, Direct Labor, Factory Overhead
  19. PROCESS COSTING SYSTEM:Data Collection, Cost of Completed Output
  20. PROCESS COSTING SYSTEM:Cost of Production Report, Quantity Schedule
  21. PROCESS COSTING SYSTEM:Normal Loss at the End of Process
  22. PROCESS COSTING SYSTEM:PRACTICE QUESTION
  23. PROCESS COSTING SYSTEM:Partially-processed units, Equivalent units
  24. PROCESS COSTING SYSTEM:Weighted average method, Cost of Production Report
  25. COSTING/VALUATION OF JOINT AND BY PRODUCTS:Accounting for joint products
  26. COSTING/VALUATION OF JOINT AND BY PRODUCTS:Problems of common costs
  27. MARGINAL AND ABSORPTION COSTING:Contribution Margin, Marginal cost per unit
  28. MARGINAL AND ABSORPTION COSTING:Contribution and profit
  29. COST VOLUME PROFIT ANALYSIS:Contribution Margin Approach & CVP Analysis
  30. COST VOLUME PROFIT ANALYSIS:Target Contribution Margin
  31. BREAK EVEN ANALYSIS MARGIN OF SAFETY:Margin of Safety (MOS), Using Budget profit
  32. BREAKEVEN ANALYSIS CHARTS AND GRAPHS:Usefulness of charts
  33. WHAT IS A BUDGET?:Budgetary control, Making a Forecast, Preparing budgets
  34. Production & Sales Budget:Rolling budget, Sales budget
  35. Production & Sales Budget:Illustration 1, Production budget
  36. FLEXIBLE BUDGET:Capacity and volume, Theoretical Capacity
  37. FLEXIBLE BUDGET:ANALYSIS OF COST BEHAVIOR, Fixed Expenses
  38. TYPES OF BUDGET:Format of Cash Budget,
  39. Complex Cash Budget & Flexible Budget:Comparing actual with original budget
  40. FLEXIBLE & ZERO BASE BUDGETING:Efficiency Ratio, Performance budgeting
  41. DECISION MAKING IN MANAGEMENT ACCOUNTING:Spare capacity costs, Sunk cost
  42. DECISION MAKING:Size of fund, Income statement
  43. DECISION MAKING:Avoidable Costs, Non-Relevant Variable Costs, Absorbed Overhead
  44. DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS
  45. DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS:MAKE OR BUY DECISIONS