Budgetary Control

1. Planning
Need to start with planning because the plan determines the budget.
The budget is a numerical plan. The budgeting process is inseparably linked to the
planning process in an organization. Major planning decisions by management are
required before the budget can be developed for the coming period.

2. Planning to Budgeting to Evaluation
These processes are interrelated and inseparable. The process is:
1. Management develops the plan.
2. That plan leads to the formulation of the budget – a quantitative expression of
the plans.
3. Budgets can lead to changes in plans and strategies because they provide
feedback to the planning process.
4. Once the plans and budgets are finalized, the plans are implemented to achieve
goals.
5. Actual results are compared to the plan – the budget is used as a control tool.
6. This control may result in the revision of prior plans, budgets and goals or in
formulation of new plans or changes in operations.
7. Changed conditions during the year will be used in planning for the next period.

3. Budgeting Overview
A budget is a quantitative (numerical) expression of the company’s plans and
objectives.
The master budget is the final, complete budget for the upcoming time period.
Operating budgets are used to identify the resources that will be needed by the
individual units to carry our planned activities.
Financial budgets identify the sources and uses of fund for the budgeted operations.

4. Advantages of Budgets
When properly done, budgets provide:
Coordination and communication among organization units and activities.
A framework for measuring performance.
Motivation for managers and employees to achieve the company’s plans.
A way to efficiently allocate the organization’s resources.
A means for controlling operations.
A means to check on progress toward the organization’s objectives.

5. Successful Budgeting Concepts
• The process must start with the company’s plans.
• The budget needs management support at all levels.
• The people who are responsible for ‘delivering’the budget must have input into
the development of the budget.
• The budget should be seen as motivational.
• The budget should be an accurate representation of expected future events.
• The budget should be flexible to allow for changes in the business environment
during the year.
• Budgeting should not be rigid that it forces actions to be taken without review by
appropriate management.
• The budget should be coordinated among all departments and divisions in the
company.
• The time period included in the budget should match the purpose of the budget.

6. Time Frames for Budgets
A budget is generally prepared for a set period of time, usually a fiscal year.
Budgets may also be set for shorter periods of time. When the budget period is the
same as the fiscal year, budget preparation is easier and comparisons between actual
results and planned results are facilitated.
A comparison between actual results and planned results is called a variance report.

7. The Budget and Control Process
The process is:
1. Senior management or a budget committee, set and communicate budget
guidelines. The budget period is determined. The initial budget guidelines
govern the preparation of the profit plan.
2. The initial budget proposals are prepared by responsibility centers. Each
responsibility center manager prepares an initial budget proposal using the
budget guidelines as well as his or her own knowledge about his or her own area
3. Company managers, at all levels from responsibility center managers to the
CEO, negotiate, review and approve the budget for submission to the board of
directors. The initial proposals are reviewed for their adherence to the budget
guidelines and to determine whether the budget goals are reasonable and in line
with the goals of the next higher unit and with those of other units. Any changes
needed are negotiated between the responsibility center managers and their
superiors.

8. The Budget and Control Process
4. After the budget is adopted, it should be able to be changed if the assumptions
upon which it was built change significantly. New information about internal or
external factors may make revision of the profit plan necessary. In addition,
periodic review of the approved budget for possible changes or use of a
continuous budget that is continually being updated might be advisable.
5. Actual results should be compared to the budget. The budget needs to be used to
monitor and control operations to meet the company’s strategic objectives. The
comparison between actual results and planned results is called variance
reporting, and it should take place at every budget unit level.
6. Variance reports at every level of the company are used to identify problem
areas and to make adjustments to operations.

9. Characteristics of Successful Budgeting Processes
• The success of a budget program depends on the attitude of top management
toward it— whether top management supports it and believes the program as vital.
• The process must have the support of management at all levels.
• The people who have the responsibility for carrying out the budget need to feel it is
their budget, not a detached, impersonal, institutional budget.
• The budget should be a motivating device.
• It as a planning and coordinating tool to help them do a better job
• The budget should be able to be revised if necessary
• The budget should be technically correct and the numbers in it should be reasonably
accurate.
• Cost management efforts should be linked to budgeting. Accurate cost information
during the budgeting process is basic to budgeting
• The development of the budget should be linked to corporate strategy. It should
begin with the company’s short- and long-term plans.
• Management should use the budget as a means of establishing goals, measuring
results, and determining areas that need attention

10. Budgetary Slack
This is the difference between what is expected to occur in the future and what is
recorded in the budget.
Managers may build budgetary slack into their budgets in order to make sure their
budgets are easily achievable.
Budgetary slack is the difference between the amount budgeted and the amount the
manager actually expects. Building in budgetary slack is the practice of
underestimating planned revenues and overestimating planned costs to make the
overall budgeted profit more achievable.

11. Budgetary Slack
Ways to reduce the incidence and effect of budgetary slack include:
• Use budgets as planning and control tools but not for manager performance
evaluation.
• Reward managers based on the accuracy of the forecasts they used in developing
their budgets.
• Use measures other than comparison of actual results to the budget to evaluate
managers.
• Top management should educate lower-level managers on the importance of
accurate budgeting.

12. Budget Methodologies

13. The Annual/Master Budget
The master budget is the culmination and the goal of the budgeting process.
This is a static budget – prepared for just one level of planned activity. The master
budget is also called the comprehensive budget. The master budget is a full set of
budgeted financial statements for the budget year, including monthly or at least
quarterly interim budgeted financial statements. The budgeted financial statements
include the budgeted balance sheet, budgeted income statement, and budgeted
statement of cash flows. A projected financial statement can be called a pro forma
financial statement; however, the master budget is not a pro forma financial
statement
The master budget is a result of both operating decisions and financing decisions.
Operating decisions are concerned with the best use of the company’s limited
resources. Financing decisions are concerned with obtaining the funds to acquire the
resources the company needs

14. A Rolling Budget
Budgets can also be prepared on a continuous basis. This type of budget is called a
rolling budget or a continuous budget.
Advantages of this approach are:
• Budgets are no longer done just once a year.
• A budget for the next period is always in place.
• The budget is more likely to be up-to-date.
• Managers are more likely to pay attention to budgeted operations for the full
budget period.

15. Operating Budgets
Used to identify the resources that will be needed to carry out the planned activities
during the budget period.
The operating budgets for individual units are compiled into the budgeted income
statement.

16. Financial Budgets
Identify the sources and uses of funds for the budgeted operations.
Financial budgets include the cash budget, budgeted statement of cash flows,
budgeted balance sheet, and the capital expenditures budget.

17. Capital Expenditures Budget
This is the budget for large, capital expenditures (fixed assets).
The capital budget is often prepared years in advance. Because capital expenditures
are large and expensive, they require advance planning to have the financing in place
and the necessary time to purchase or construct the assets so they will be available
when they are needed.
Any capital expenditures to be made during the budget year will need to be included
in the budgeting process for the year. Capital expenditures budgeted for the coming
year will affect the Budgeted Balance Sheet as increases in fixed assets and in
accounts receivable, inventory, and accounts payable.

18. Master Budget
The master budget is the goal of and result of the budgeting process. It is a
compilation of all separate operational and financial budget schedules. The budgeted
financial statements include the budgeted balance sheet, budgeted income statement,
and budgeted statement of cash flows. The budgeted financial statements are prepared
by responsibility center, and the responsibility center budgeted statements are
consolidated into the company-wide budgeted financial statements.
The development of an annual profit plan for a large corporation may take many
months to complete because the annual profit plan is made up of several different
budgets, and some budgets cannot be developed until other budgets have already
been completed. For example, the Sales Budget will be the driving factor in
determining how many units must be produced, and therefore the Sales Budget must
be completed before the production budget can be completed.

19. Master Budget
The master budget is prepared for just one planned activity level.
The master budget consists of two classifications:
• The operating budget, and
• The financial budget.
The Operating Budget includes Sales Budget, Production Budget, Direct Materials
Usage Budget, Direct Materials Purchases Budget, Direct Labor Usage Budget,
Manufacturing Overhead Costs Budget, Ending Inventories Budgets (Finished Goods
and Direct Materials), Budgeted Cost of Goods Manufactured, Budgeted Cost of
Goods Sold
The Financial Budget includes, Capital Expenditures Budget, Cash Budget, Budgeted
Balance Sheet, Budgeted Statement of Cash Flows

20. Operating Budget
Includes the income statement and all the budgets that support it:
• Sales budget
• Production budget
• Direct materials usage budget
• Direct materials purchases budget
• Direct labor budget
• Manufacturing overhead costs budget
• Ending inventories budget (finished goods and direct materials)
• Cost of goods sold budget
• Nonmanufacturing budgets

21. Financial Budget
The financial budget includes:
• Capital expenditures budget
• Cash budget
• Budgeted balance sheet
• Budgeted statement of cash flows

22. Preparing the Individual
Budgets

23. The Individual Budgets
A number of budgets need to be prepared in order to prepare the master budget.
Some of them need to be prepared in a specific order because some of the budgets
build on each other.
• The sales budget is the first budget prepared.
• The cash budget is the last budget prepared.

24. 1. The Sales Budget
This is the first budget to complete. Everything the company will do during the year is
based on how many units they expect to sell.
This is also the hardest budget to prepare. Considerations in developing the Sales Budget
include both external and internal factors.
External factors include:
• The current economic environment
• Consumer attitudes regarding the company’s products
• Competitors’ actions and plans
• The projected level of industry sales, the company’s current and projected market share
and
• company’s position within the industry with respect to its degree of influence or
dominance.
Internal factors include:
• Pricing policy, Credit policies, anticipated changes to credit policies, Current and
future availability of resources

25. PRACTICE QUESTION
Easecom manufactures products for networking video-conferencing equipment. Production of specialized
units is, to a large extent, performed under contract, with standard units manufactured to marketing
projections. Maintenance of customer equipment is an important area of customer satisfaction. Easecom’s
income statement for the fiscal year ended October 31, Year 1, is presented below.
Easecom Income Statement For the Year Ended October 31, Year 1 ($000 omitted)
Net sales:
Equipment $6,000
Maintenance contracts 1,800
Total net sales 7,800
Expenses:
Cost of goods sold 4,600
Customer maintenance 1,000
Selling expense 600
Administrative expense 900
Interest expense 150
Total expenses 7,250

26. PRACTICE QUESTION
Easecom manufactures products for networking video-conferencing equipment.
Production of specialized units is, to a large extent, performed under contract, with
standard units manufactured to marketing projections. Maintenance of customer
equipment is an important area of customer satisfaction. Easecom’s income statement for
the fiscal year ended October 31, Year 1, is presented below.
Easecom Income Statement For the Year Ended October 31, Year 1 ($000 omitted)
Income before income taxes 550
Income taxes 220
Net income $ 330
Easecom’s management considered the growing video-conferencing market when it
proposed the following actions for fiscal Year 2:
• Increase equipment sales prices by 10%.
• Increase the cost of each unit sold by 3% for needed technology and quality
improvements, and increased variable costs.

27. PRACTICE QUESTION
Increase maintenance inventory by $250,000 at the beginning of the year and add two
maintenance technicians at a total cost of $130,000 to cover wages and related travel
expenses. These revisions are intended to improve customer service and response
time. The increased inventory will be financed at an annual interest rate of 12%; no
other borrowings or loan reductions are contemplated during fiscal Year 2. All other
assets will be held to fiscal Year 1 levels.
• Increase selling expenses by $250,000 but hold administrative expenses at Year 1
levels.
• The effective rate for Year 2 federal and state taxes is expected to be 40%, the
same as Year 1.
These actions are expected to increase equipment unit sales by 6%, with a
corresponding 6% growth in maintenance contracts.
In its pro forma income statement for the fiscal year ending October 31, Year 2,
Easecom estimated that total net sales will be

28. ANSWER
Equipment unit sales and price are projected to increase by 6% and 10%,
respectively. Hence, equipment sales are projected to be $6,996,000 ($6,000,000 for
the year ended 10/31/Year 1 × 1.06 × 1.10). Maintenance contracts are projected to
be increased by 6%. Hence, maintenance sales are projected to be $1,908,000
($1,800,000 for the year ended 10/31/Year 1 × 1.06). The pro forma total net sales
will therefore be $8,904,000 ($6,996,000 + $1,908,000).

29. 2. The Production Budget
The production budget can be prepared only after the sales budget is completed.
Production budget is based on:
• The expected level of sales,
• Desired change to the level of inventory,
• Any decisions about outsourcing production.
If the company would like to increase its finished goods inventory level by year-end,
it will need to include the desired inventory increase in its production plans.

30. Production Sub-Budgets
Once the production budget is completed, detailed budgets for
• Materials usage
• Materials purchases
• Labor usage
• Manufacturing overheads
also need to be prepared.

31. 2A. Direct Materials Usage Budget
The number of units to be produced is used to calculate the amount of direct materials
required and their cost.

32. 2B. Direct Material Purchases Budget
The direct material purchases budget is derived from the direct material usage budget.

33. PRACTICE QUESTION
A company manufactures electronic components used in automobile manufacturing.
Each component uses two raw materials, G and C. Standard usage of the two
materials required to produce one finished electronic component, as well as the
current inventory, are shown below.
Standard
Material Per Unit Price Current Inventory
G 2.0 pounds $15/lb. 5,000 pounds
C 1.5 pounds $10/lb 7,500 pounds
The company forecasts sales of 20,000 components for the next two production
periods. Company policy dictates that 25% of the raw materials needed to produce the
next period’s projected sales be maintained in ending direct materials inventory.
Based on this information, the budgeted direct material purchases for the coming
period would be

34. ANSWER
The company’s budgeted direct materials purchases can be calculated as follows:
G C
Projected unit sales 20,000 20,000
Times: Pounds per unit × 2.0 × 1.5
Inputs required 40,000 30,000
Add: Required ending inventory 10,000 7,500
Less: Beginning inventory (5,000) (7,500)
Unit purchases 45,000 30,000
Times: Unit cost × $15 × $10
Cash purchases $675,000 $300,000

35. PRACTICE QUESTION
Data regarding a budget are shown below.
Planned sales 4,000 units
Material cost $2.50 per pound
Direct labor 3 hours per unit
Direct labor rate $7 per hour
Finished goods beginning inventory 900 units
Finished goods ending inventory 600 units
Direct materials beginning inventory 4,300 units
Direct materials ending inventory 4,500 units
Materials used per unit 6 pounds
The production budget will show total units to be produced of

36. ANSWER
The required production for the year can be calculated as follows:
Sales for year 4,000
Add: Ending finished goods inventory 600
Less: Beginning finished goods inventory (900)
Required production 3,700

37. 2C. Direct Labor Budget
The direct labor budget is developed using direct labor standards to calculate the
budgeted cost for direct labor.
The cost per hour of direct labor time will generally include wages and all other
employee costs.

38. PRACTICE QUESTION
Jordan Auto has developed the following production plan:
Month Units
January 10,000
February 8,000
March 9,000
April 12,000
Each unit contains 3 pounds of direct materials. The desired direct materials ending inventory each
month is 120% of the next month’s production, plus 500 pounds. (The beginning inventory meets
this requirement.) Jordan has developed the following direct labor standards for production of these
units:
Department 1 Department 2
Hours per unit 2.0 0.5
Hourly rate $7.25 $12.00
Jordan Auto’s total budgeted direct labor dollars for February usage should be

39. ANSWER
The standard unit labor cost is $20.50 [($7.25 × 2 hours in Department 1) + ($12 × .5
hour in Department 2)], so the total budgeted direct labor dollars for February equal
$164,000 (8,000 units × $20.50).

40. 2D. Manufacturing Overhead Costs
Traditionally, overhead costs are allocated to units produced using either machine
hours or direct labor hours. Both budgeted fixed and variable overhead costs are
totaled.

41. 3. Ending Inventory Budget
The ending inventory budget for both finished goods and direct materials is prepared.

42. Cost of Goods Manufactured Budgets
Budgeted Direct Materials Used
+ Budgeted Direct Labor Used
+ Budgeted Manufacturing Overhead Applied
= Budgeted Total Manufacturing Costs
+ Budgeted Beginning Work-in-Process Inventory − Budgeted Ending Work-in-
Process Inventory
= Budgeted Cost of Goods Manufactured

43. 4. Cost of Goods Sold Budget
Beginning Inventory
+ Expected Budgeted Purchases or Production
= Expected Goods Available for Sale
− Desired Ending Inventory
= Budgeted Cost of Goods Sold

44. PRACTICE QUESTION
Easecom manufactures products for networking video-conferencing equipment. Production of specialized
units is, to a large extent, performed under contract, with standard units manufactured to marketing
projections. Maintenance of customer equipment is an important area of customer satisfaction. Easecom’s
income statement for the fiscal year ended October 31, Year 1, is presented below.
Easecom Income Statement For the Year Ended October 31, Year 1 ($000 omitted)
Net sales:
Equipment $6,000
Maintenance contracts 1,800
Total net sales 7,800
Expenses:
Cost of goods sold 4,600
Customer maintenance 1,000
Selling expense 600
Administrative expense 900
Interest expense 150
Total expenses 7,250

45. PRACTICE QUESTION
Easecom manufactures products for networking video-conferencing equipment.
Production of specialized units is, to a large extent, performed under contract, with
standard units manufactured to marketing projections. Maintenance of customer
equipment is an important area of customer satisfaction. Easecom’s income statement for
the fiscal year ended October 31, Year 1, is presented below.
Easecom Income Statement For the Year Ended October 31, Year 1 ($000 omitted)
Income before income taxes 550
Income taxes 220
Net income $ 330
Easecom’s management considered the growing video-conferencing market when it
proposed the following actions for fiscal Year 2:
• Increase equipment sales prices by 10%.
• Increase the cost of each unit sold by 3% for needed technology and quality
improvements, and increased variable costs.

46. PRACTICE QUESTION
Increase maintenance inventory by $250,000 at the beginning of the year and add two
maintenance technicians at a total cost of $130,000 to cover wages and related travel
expenses. These revisions are intended to improve customer service and response
time. The increased inventory will be financed at an annual interest rate of 12%; no
other borrowings or loan reductions are contemplated during fiscal Year 2. All other
assets will be held to fiscal Year 1 levels.
• Increase selling expenses by $250,000 but hold administrative expenses at Year 1
levels.
• The effective rate for Year 2 federal and state taxes is expected to be 40%, the
same as Year 1.
These actions are expected to increase equipment unit sales by 6%, with a
corresponding 6% growth in maintenance contracts.
In its pro forma income statement for the year ended October 31, Year 2, Easecom
estimated that cost of goods sold will be

47. ANSWER
The cost and unit sales of equipment are projected to increase by 3% and 6%,
respectively. Accordingly, pro forma cost of goods sold will be $5,022,280
($4,600,000 for the year ended 10/31/Year 1 × 1.03 × 1.06).

48. 5. Nonmanufacturing Budgets
Selling and marketing budget
General and administrative budget
Accounting and finance budget
Research and development budget
Any budget for other type of revenue or expense that the company has during the
budgeted period

49. The Financial Budgets
The financial budget is the budgeted balance sheet and statement of cash flows, cash
budget and capital budget.

50. The Cash Budget
This is the last budget prepared because all other budgets go into this budget. Cash
budget will be prepared on a monthly basis.
The Cash Budget (also called the Cash Management, Cash Flow or Working Capital
Budget) draws on information from all the other budgets. The Cash Budget tracks the
inflows and outflows of cash on a month-by-month.
The Cash Budget is similar to but not exactly the same as a Budgeted Statement
of Cash Flows.
• Whereas the cash flows in the Budgeted Statement of Cash Flows are segregated
according to operating, investing, and financing cash flows, the cash flows in the
Cash Budget are segregated according to receipts and disbursements.
• The Cash Budget must be prepared before the Budgeted Balance Sheet can be
prepared. On the other hand, the Budgeted Statement of Cash Flows must be
prepared after the Budgeted Balance Sheet and Income Statement are prepared.

51. PRACTICE QUESTION
Tidwell Corporation sells a single product for $20 per unit. All sales are on account,
with 60% collected in the month of sale and 40% collected in the following month. A
partial schedule of cash collections for January through March of the coming year
reveals the following receipts for the period:
Cash Receipts
January February March
December receivables $32,000
From January sales 54,000 $36,000
From February sales 66,000 $44,000

52. PRACTICE QUESTION
Other information includes the following:
Inventories are maintained at 30% of the following month’s sales.
Tidwell desires to keep a minimum cash balance of $15,000. Total payments in
January are expected to be $106,500, which excludes $12,000 of depreciation
expense. Any required borrowings are in multiples of $1,000.
The December 31 balance sheet for the preceding year revealed a cash balance of
$24,900.
Ignoring income taxes, the financing Tidwell will need in January to maintain the
firm’s minimum cash balance is

53. ANSWER
Tidwell’s ending cash balance for January is calculated as follows:
Beginning balance of cash $ 24,900
Add: cash receipts 86,000
Cash available $110,900
Less: payments (106,500)
Ending cash before borrowing $ 4,400
To reach the minimum acceptable cash balance of $15,000, the company will need to
borrow at least $10,600. Since loans are in multiples of $1,000, the borrowing must
be rounded up to $11,000.

54. PRACTICE QUESTION
Historically, Pine Hill Wood Products has had no significant bad debt experience with
its customers. Cash sales have accounted for 10% of total sales, and payments for
credit sales have been received as follows:
40% of credit sales in the month of the sale
30% of credit sales in the first subsequent month
25% of credit sales in the second subsequent month
5% of credit sales in the third subsequent month

55. PRACTICE QUESTION
The forecast for both cash and credit sales is as follows:
Month Sales
January $95,000
February 65,000
March 70,000
April 80,000
May 85,000
What is the forecasted cash inflow for Pine Hill Wood Products for May?

56. ANSWER
The cash inflows for May will come from May cash sales of $8,500 ($85,000 ×
10%), May credit sales of $30,600 ($85,000 × 90% × 40%), April sales of $21,600
($80,000 × 30% × 90%), March sales of $15,750 ($70,000 × 25% × 90%), and
February sales of $2,925 ($65,000 × 5% × 90%). The total is $79,375..

57. Master Budget Financial Statements
These budgeted financial statements are what the company’s financial statements will
look like next year if reality exactly matched the budgeted amounts. The individual
budgets that make up the Operating and Financial Budgets are compiled into a
Budgeted Income Statement, Balance Sheet, and Statement of Cash Flows. The
budgeted financial statements are interconnected in the same manner as are financial
statements that report actual results.

58. Who Should Prepare the Budget
Participative budgeting involves individuals impacted by the budget. It is developed
from the bottom up. This type of budget development involves negotiation between
lower-level managers and senior managers.
Authoritative budgets are set by management. Senior management prepares all the
budgets for every segment of the organization. The budgets are imposed upon the
lower-level managers and employees.
Consultative budgeting – Management asks for input, but then makes budget
without any joint decision making. Senior management asks for input from lower
level managers but then develops the budget with no joint decision-making or
negotiation involved.

59. Responsibility Centers and Controllable Costs
Control in an organization is exercised through responsibility centers. Therefore,
budgeting must also be done at the responsibility center level.
Controllable costs are costs for which the manager has the authority to make the
decisions about how money will be spent. Non-controllable costs are costs that are
ordinarily controlled at a higher level in the organization, such as the manager’s
salary or bonus. The manager’s salary or bonus is controllable, but not by the
manager.
Each budgeted cost assigned to a responsibility center should be identified as either
controllable or non- controllable by that responsibility center’s management. For
example, salaries in the accounting system may be segregated in two accounts:
controllable salaries and non-controllable salaries. All costs should be included on
some manager’s variance report and identified as the responsibility of the manager on
whose report they appear

60. Flexible Budgets
This is the process of producing budgets for different levels of activity. This makes the
evaluation process better. A flexible budget requires standard costs.
When a company develops its budget for a future period, it does not know what its actual
sales and production volumes will be during that period. Static budget produced for one
level of income.
A flexible budget is a budget that is prepared after the actual level of activity is known.
A flexible budget is prepared after the actual level of activity is known. A flexible
budget for a production department will consist of the budgeted variable amounts per unit
adjusted to the actual volume of units produced. A flexible budget for an income statement
will be adjusted to the actual volume of units sold. The flexible budget is prepared for the
actual level of activity using all of the standard variable costs per unit along with the
standard total fixed cost as determined at the beginning of the year.

61. Using the Flexible Budget
Actual results are compared to the flexible budget to determine where things were
different.
Significant variances are investigated.
In a flexible budget only the variable budgeted revenues and costs are adjusted.
Only variable revenues and costs change with changes in volume. Fixed costs are
just fixed. Therefore, the fixed costs in the flexible budget are exactly the same as
the fixed costs in the static budget.
The flexible budget can be prepared only after the end of a period, when the actual
volume for the period is known. Therefore, a flexible budget would be prepared for
each month or each quarter as well as for the year-end, but only when the actual
volume for that period is known.

62. Overhead Standards
Overhead standards are generally based on normal operating conditions, normal
volume, and desired efficiency. Overhead can be either variable overhead for which
costs fluctuate with changes in production volume (for example, disposable tools), or
it can be fixed overhead that does not fluctuate with changes in production volume.
The total overhead costs come from the budgeted factory overhead costs.
These are divided by a predetermined level of activity to calculate a standard
overhead rate.

63. Example: Here is an income statement showing actual results alongside the static
budget (the master budget) and the flexible budget prepared for the actual sales
volume:
Actual Static Flexible
Results Budget Budget
Units sold 20,000 24,000 20,000
Revenues $2,500,000 $2,880,000 $2,400,000
Variable costs:
Direct materials 1,243,200 1,440,000 1,200,000
Direct manufacturing labor 396,000 384,000 320,000
Variable manufacturing overhead 261,000 288,000 240,000
Total variable costs $1,900,200 $2,112,000 $1,760,000
Contribution margin $ 599,800 $ 768,000 $ 640,000
Fixed costs 570,000 552,000 552,000
Operating income $ 29,800 $ 216,000 $ 88,000

64. Project Budget
A budget for a specific project.
The time frame of the budget may be very short or more long-term, depending upon
the length of the project.
All project budgets need to be incorporated into the larger budgeting process for the
company.
A long-term project budget for the introduction of a new product can also be called a
life-cycle budget. A life-cycle budget plans incomes and expenses for one specific
product throughout its entire life cycle, from its development through its decline

65. Activity-Based Budgeting
Activity-based budgets are prepared based on the activities that incur costs how much
they are performed.
• Activities that drive the costs are identified.
• A budgeted level of activity for each of these drivers is determined based on a
budgeted level of production.
• Budgets are developed based on budgeted activity levels and the costs to perform
them.
If activity-based costing is used as the costing system, then the budget should also
be activity- based to enable continuous improvement and also to make
comparisons between actual results and budgeted results meaningful.

66. Zero-Based Budgeting
This system starts each year with a blank page, and all items are created new for the
year.
All revenues need to be planned for each year.
All expenses need to be accounted for and justified.
Under zero-based budgeting, the budget is prepared without any reference to, or
use of, the current period’s budget or the likely operating results for the current
period. Every planned activity must be justified with a cost-benefit analysis.
The major limitation of zero-based budgeting is that it can require a nearly
impossible amount of work to review all of a company’s activities every year.

67. PRACTICE QUESTION
Super Drive, a computer disk storage and back-up company, uses accrual accounting. The
company’s Statement of Financial Position for the year ended November 30 is as follows:
Super Drive
Statement of Financial Position as of November 30
Assets Liabilities and Stockholders’ Equity
Cash $ 52,000 Common stock $ 175,000
Accounts receivable, net 150,000 Accounts payable 900,000
Inventory 315,000 Retained earnings 442,000
Property, plant, and 1,000,000
Equipment Total liabilities and
Total assets $1,517,000 stockholders’ equity $1,517,000

68. PRACTICE QUESTION
Additional information regarding Super Drive’s operations include the following:
Sales are budgeted at $520,000 for December and $500,000 for January of the next
year.
Collections are expected to be 60% in the month of sale and 40% in the month
following the sale.
Eighty percent of the disk drive components are purchased in the month prior to the
month of sale, and 20% are purchased in the month of sale. Purchased components
are 40% of the cost of goods sold.
Payment for the components is made in the month following the purchase.
Cost of goods sold is 80% of sales.
Super Drive’s projected gross profit for the month ending December 31 is

69. ANSWER
Given that cost of goods sold is 80% of sales, gross profit is 20% of sales.
Consequently, pro forma gross profit is $104,000 ($520,000 × 20%).