- The document discusses budgeting and profit planning. It defines a budget as a comprehensive financial plan for an organization's operations and resources for a specified future period. - Budgets have several purposes including explicitly stating expectations, communicating goals, coordinating activities, and establishing a framework to evaluate performance. - The master budget includes operating budgets for items like sales, production and expenses. It also includes financial budgets for the income statement, cash flows, and balance sheet. Cash budgets specifically help plan and control cash flows over a period.

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Chapter 17Chapter 17
Budgeting and ProfitBudgeting and Profit
PlanningPlanning

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BUDGETING AND PROFIT
PLANNING
Planning Process
Preparation/Types of Budgets
Budget-Definition, Meaning
and Purpose

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Planning ProcessPlanning Process
Budgeting is a tool of planning. Planning involves specification of
the basic objectives that the organisation will pursue and the
fundamental policies that will guide it. In operational terms,
it involves four steps:
(1) Objectives
Objectives are broad and long-range desired state or position in future.
(2) Goals
Goals are quantitative targets to be achieved in specified period.
(3) Strategies
Strategies represent specific course of action to achieve goals.
(4) Plans
The final step is the preparation of budgets/profit plans. It converts goals
and strategies into annual operating plans..

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BudgetBudget
A budget is defined as a comprehensive and coordinated plan,
expressed in financial terms, for the operations and resources
of an enterprise for some specified period in the future.
The essential elements of a budget are:
(1) Plan
(2) Financial terms
(3) Operations and resources
(4) Specific future period
(5) Comprehensive coverage
(6) Coordination

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The first ingredient of a budget is its plan. It includes two aspects which
have a bearing on the operations of an enterprise. One set of factors, which
determine a firm’s future operations are wholly external and beyond its
control. The second set of factors affecting future activities are within the
firm’s control and discretion, that is, they are internal.
A budget is a mechanism to plan for the firm’s operations and resources.
The operations are reflected in revenues and expenses.
The plan also covers the resources of the firm. The planning of resources
means the planning of the various assets and the sources of capital to
finance these assets. The assets could be fixed assets as well as current
assets.
Budgets are prepared in financial terms, that is, in terms of monetary value
such as the rupee, dollar, and so on. The reason is that the monetary unit is
a common denominator.
1. Plan
2. Operations and Resources
3. Financial Terms

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A budget relates to a specified period of time, usually one year.
A budget is comprehensive in that all the activities and operations of
an organisation are included in it. It covers the organisation as a
whole and not only some segments. The modus operandi is that
budgets are prepared for each segment/facet/activity/division of an
organisation.
Budgets are prepared for the different components/
segments/divisions/ facets/activities of an organisation so as to take
care of the situations and problems of each component. The
budgets for each of the components are prepared in harmony with
each another. This is called coordination.
4. Specified Future Period
5. Comprehensiveness
6. Coordination

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Budget PurposeBudget Purpose
The main objectives of budgeting are:
1. Explicit statement of expectations
2. Communication
3. Coordination,
4. Expectations as a framework for judging performance

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One purpose of budgeting is to state expectations in formal terms so that
most of the underlying assumptions may be identified. A firm has the
basic objective of optimising long-run profit. Its long-range goals
also include survival, consumer satisfaction, employee
welfare, personal power and prestige, and so on.
Another purpose of budgeting is to communicate or inform others of the
goals and methods selected by top management. Since budgeting
deals with fundamental policies and objectives, it is
prepared by top management.
However, a budget does not lay down a statement of expectations in rigid
terms. A budget should be modified when necessary in the light of
the changes in the factors/assumptions on which the
original estimates were based.
1. Explicit Statement of Expectations
2. Communication

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Yet another purpose of budgeting is coordination. The term ‘coordination’
refers to the operation of all departments of an organisation in
such a way that there is no bottleneck or imbalance.
Finally, a budget establishes expectations as a framework for judging
employee performance.
In view of the above, coordination is a major function of budgeting.
Budgets should be drafted in such a way that the operations
of the various departments are related to each other for
the achievement of the overall goal.
3. Coordination
4. Expectations as a Framework for Judging Performance

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TYPES OF BUDGETSTYPES OF BUDGETS
The overall budget is known as the master budget. A
master budget normally consists of three
types of budgets:
(i) Operating Budgets(i) Operating Budgets
(ii) Financial Budgets(ii) Financial Budgets
(iii) Special Decision Budgets(iii) Special Decision Budgets

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1. Operating Budget1. Operating Budget
1) Sales budget,
2) Production budget,
3) Purchase budget,
4) Direct labour budget,
5) Manufacturing expenses budget, and
6) Administrative and selling expenses budget, and
so on.
Operating budgets relate to physical activities/
operations such as sales, production,
and so on.
Operating budget has the following components

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2. Financial Budget2. Financial Budget
1) Budgeted income statement,
2) Budgeted statement of retained earnings,
3) Cash budget, and
4) Budgeted balance sheet.
Financial budgets are concerned with expected
cash flows, financial position and
result of operations.
Financial budget has the following components

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Cash BudgetCash Budget
Cash budget is a device to help a firm to plan for and control the use of
cash. It is a statement showing the estimated cash inflows and cash
outflows over the planning period. The principal aim of the cash
budget, as a tool to predict cash flows over a period of time,
is to ascertain whether there is likely to be excess/shortage of cash at any
time.
The preparation of a cash budget involves several steps.
The first element of a cash budget is the selection of the period of
the budget, that is, the planning horizon.
The second element of the cash budget is the selection/identification
of the factors that have a bearing on cash flows.
The factors that generate cash are generally divided into two broad
categories:
(i) Operating (ii) Financial

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Operating Cash FlowOperating Cash Flow
The main operating factors/items which generate cash
outlfows and inflows over the time span of a
cash budget are tabulated in Exhibit 1.
Exhibit 1. Operating Cash Flow Items
Cash inflows/Receipts Cash outflows/Disbursements
1.Cash sales
2.Collection of accounts
receivable
3.Disposal of fixed assets
1. Accounts payable/Payable payments
2. Purchase of raw materials
3. Wages and salary (pay roll)
4. Factory expenses
5. Administrative and selling expenses
6. Maintenance expenses
7. Purchase of fixed assets

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Financial Cash Flow ItemsFinancial Cash Flow Items
The major financial factors/items affecting generation
of cash flows are depicted in Exhibit 2.
Exhibit 2. Financial Cash Flow Items
Cash inflows/Receipts Cash outflows/Payments
1. Loans/borrowings
2. Sale of securities
3. Interest received
4. Dividend received
5. Rent received
6. Refund of tax
7. Issues of new shares and
securities
1. Income tax/tax payments
2. Redemption of loan
3. Re-purchase of shares
4. Interest paid
5. Dividends paid

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Example 1
The following data relate to Hypothetical Limited:
Balance Sheet as at March 31, Current Year
Liabilities Amount Assets Amount
Accounts payable
(all for March purchases)
Taxes payable
(all for March income)
Share capital
Retained earnings
Rs 40,000
25,000
11,00,000
10,26,800
_______
21,91,800
Cash
Accounts receivable
(all from March sales)
Inventories:
Raw materials (9,600 kgs ×Rs 3)
Finished goods
(1,800 units ×Rs 35)
Fixed assets:
Cost Rs 20,00,000
Less: Accumulated
depreciation (4,50,000)
Rs 3,00,000
2,50,000
28,800
63,000
15,50,000
21,91,800

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2. Sales forecasts: Assume the marketing department has developed the
following sales forecast for the first quarter of the next year and the selling
price of Rs 50 per unit.
Month Units sales
April
May
June
9,000
12,000
16,000
3. The management desires closing inventory to equal 20 per cent of the
following month’s sales.
4. The manufacturing costs are as follows
Direct materials: (5 kgs ×Rs 3) (per unit)
Direct labour
Variable overheads
Total fixed overheads (per annum)
Rs 15
5
9
7,20,000
5. Normal capacity is 1,20,000 units per annum. Assume absorption costing
basis.
6. Each unit of final product requires 5 kgs of raw materials. Assume
management desires closing raw material inventory to equal 20 per cent
of the following month’s requirements of production.

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7. Assume fixed selling and administrative expenses are Rs 20,000 per
month and variable selling and administrative expenses are Rs 5 per
unit sold.
8. All sales are on account. Payment received within 10 days from the date
of sale are subject to a 2 per cent cash discount. In the past, 60 per cent
of the sales were collected during the month of sale and 40 per cent are
collected during the following month. Of collections during the month of
sale, 50 per cent are collected during the discount period. Accounts
receivable are recorded at the gross amount and cash discounts are
treated as a reduction in arriving at net sales during the month they are
taken.
9. Tax rate is 35 per cent.
10. Additional information:
(a) All purchases are on account. Two-thirds are paid for in the month
of purchase and one-third, in the following month.
(b) Fixed manufacturing costs include depreciation of Rs 20,000 per
month.
(c) Taxes are paid in the following month.
(d) All other costs and/or expenses are paid during the month in which
incurred.
From the foregoing information prepare a master budget for the month of
April only.

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Solution
1.Production Budget
Particulars April May
Sales (units)
Add: Desired closing inventory (0.20 ×next month’s sales)
Total finished goods requirement
Less: Opening inventory
Required production (units)
9,000
2,400
11,400
(1,800)
9,600
12,000
3,200
15,200
(2,400)
12,800
2.Manufacturing Cost Budget
Particulars April
Required production (units)
Direct material cost (5 kgs ×Rs 3 per kg)
Total direct material cost
Total direct labour cost (Rs 5 per unit)
Total variable overhead cost (Rs 9 per unit)
Total variable manufacturing costs
All fixed manufacturing overheads (Rs 7,20,000 ÷ 12 months)
Total manufacturing cost
9,600
×Rs 15
Rs 1,44,000
48,000
86,400
2,78,400
60,000
3,38,400

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3.Purchase Budget (Raw Materials)
Particulars April May
Production requirement (units)
Raw material required for production @ 5 kgs per unit
(kgs)
Add: Desired closing inventory (0.20 ×May
requirements)
Total requirements
Less: Opening inventory
Purchase requirement
Purchase requirement (amount @ Rs 3 per kg)
9,600
______
48,000
12,800
60,800
(9,600)
51,200
Rs 1,53,600
12,800
_____
64,000
4.Selling and Administrative Expenses Budget
Particulars April
Units sales
Variable costs @ Rs 5 per unit
Fixed costs
Total selling and administrative expenses
9,000
Rs 45,000
20,000
65,000

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5. Cost of Goods Sold Budget
Particulars April
Units sold
Cost per unit
Variable
Fixed (Rs 60,000 ÷ 10,000 units)
Total cost
Rs 29
6
9,000
×Rs 35
3,15,000
6. Budgeted Income Statement for the Month of April
Gross sales (9,000 ×Rs 50)
Less: Cash discount (Rs 4,50,000 ×0.6 ×0.5 ×0.02)
Net sales
Less: Cost of goods sold
Gross margin (unadjusted)
Less: Capacity variance unfavourable (400 units ×Rs 6)
Gross margin (adjusted)
Less: Selling and administrative expenses
Earnings before taxes
Less: Taxes (0.35)
Earning after taxes
Rs 4,50,000
2,700
4,47,300
3,15,000
1,32,300
2,400
1,29,900
65,000
64,900
22,715
42,185

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7.Budgeted Statement of Retained Earnings
Opening balance
Add: Earnings after taxes
Closing balance
Rs 10,26,800
42,185
10,68,985
8.Cash Budget (April)
Opening balance
Cash inflows:
Collection from debtors:
March sales
April sales (gross) (Rs 4,50,000 ×
0.60)
Less: Cash discount
(Rs 2,70,000 ×0.5 ×0.02)
Cash outflows:
Payment to creditors:
For March purchases
For April purchases (Rs 1,53,600
×2/3)
Direct labour
Variable manufacturing overhead
Fixed manufacturing overhead
Less: Depreciation
Variable selling and administrative
overheads
Fixed selling and administrative
overheads
Taxes
Closing balance
Rs 2,70,000
2,700
Rs 2,50,000
2,67,300
40,000
1,02,400
60,000
(20,000)
Rs 3,00,000
5,17,300
1,42,400
48,000
86,400
40,000
45,000
20,000
25,000
Rs 8,17,300
4,06,800
4,10,500

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9. Proforma Balance Sheet as at April 30th, Next Year
Liabilities Amount Assets Amount
Accounts payable
(Rs 40,000 +
Rs 1,53,600 –
Rs 1,42,400)
Taxes payable
(Rs 25,000 + Rs 22,715
– Rs 25,000)
Share capital
Retained earnings
Rs 51,200
22,715
11,00,000
10,68,985
________
22,42,900
Cash
Accounts receivable
(Rs 4,50,000 ×0.40)
Inventories:
Raw material
(12,800 ×Rs 3)
Finished goods
(2,400 ×Rs 35)
Fixed assets:
Cost
Less: Accumulated
depreciation
Rs 38,400
84,000
20,00,000
(4,70,000)
Rs 4,10,500
1,80,000
1,22,400
15,30,000
22,42,900

24. Example: Prepare a cash budget for the three months ending 30th June 2009 from
the following information given below:
a)
Month Sales Materials Wages Overheads
(Rs.) (Rs.) (Rs.) (Rs.)
Feb 14000 9600 3000 1700
March 15000 9000 3000 1900
April 16000 9200 3200 2000
May 17000 10000 3600 2200
June 18000 10400 4000 2300
b) Credit terms are:-
Sales /Debtor - 10% sales are on cash, 50% of the credit sales are collected next month
and the balance in the following month.
Creditors - Materials - 2 months
Wages - 1/4 month
Overheads - 1/2 month
c) Cash and Bank balance as on 1st April, 2009 is expected to be Rs.6000.

25. d) Other relevant information is:
i) Plant and Machinery will be installed in Feb 2009 at a cost of
Rs.96000.
The monthly instalments of Rs. 2000 is payable from April
onwards.
ii) Dividend @ 5% on preferences share capital of Rs.200000
will be paid
on 1st June.
iii) Advances to be received for sale of vehicles Rs.9000 in June.
iv) Dividends from investments amounting to Rs.1000 are
expected to be
received in June.
v) Income tax (advance) to be paid in June
Rs.2000.

26. Solution:
Cash Budget
(for the period April to June 2009)
April May June Total
(Rs.) (Rs.) (Rs.) (Rs.)
1) Balance B/F 6000 3950 3000 6000
2) Receipts
Sales (Note 1) 14650 15650 16650 46950
Dividend 1000 1000
Adv agst Vehicle 9000 9000
Total 20650 19600 29650 62950
3) Payments
Creditors (mat) 9600 9000 9200 27800
Wages 3150 3500 3900 10550
Overheads 1950 2100 2250 6300
Capital Expends 2000 2000 2000 6000
Dividend (preferen) 10000 10000
Adv Income tax 2000 2000
Total 16700 16600 29350 62650
Balance C/F 3950 3000 300 300

27. Working Notes:
1) Collection from sales /Debtors
Related Moth Calculation April May June
(Rs.) (Rs.) (Rs.)
Feb (14000 -10% of 14000)X 50% 6300
March (15000 -10% of 15000) X 50% 6750 6750
April (10% of 16000) 1600
(16000-10% of 16000)X 50% 7200 7200
May (10% of 17000) 1700
(17000-10% of 17000) 7650
June (10% of 18000) 1800
Total 14650 15650 16650

28. 2) Payment for creditors, wages and overhead have been computed on the same
Pattern.
Related Moth Calculation April May June
(Rs.) (Rs.) (Rs.)
Materials:
Feb (To be paid in April) 9600
March (To be paid in May) 9000
April (To be paid in June) 9200
Total 9600 9000 9200
Wages:
March (25% to be paid in April) 750
April (75% to be paid in same month) 2400
(25% to be paid in May) 800
May (75% to be paid in same month) 2700
(25% to be paid in June) 900
June (75% to be paid in same month) 3000
Total 3150 3500 3900
Overheads:
March (50% to be paid in April) 950
April (50% to be paid in same month) 1000
(50% to be paid in May) 1000
May (50% to be paid in same month) 1100
(50% to be paid in June) 1100
June (50% to be paid in same month) 1150
Total 1950 2100 2250

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Special Decision BudgetsSpecial Decision Budgets
The third category of budgets are special decision
budgets. They relate to inventory levels, break-even
analysis, and so on.
Fixed Budgets
Budgets prepared at a single level of activity, with no prospect of
modification in the light of changed circumstances, are referred to
as fixed budgets.
Flexible Budgets
The alternative to fixed budgets are flexible/variable/sliding
budgets
Fixed and Flexible BudgetsFixed and Flexible Budgets

30. Flexible Budget
A flexible estimates costs at several levels of activity. The merit of a
flexible budget is that instead of one estimate it contains several
estimates / plans in different assumed circumstances. Since the
business activities cannot be accurately predicted as the business
conditions / environment are uncertain, it is useful tool in real business
situations, that is, an unpredictable environment. In view of its
significance as a more realistic basis of budgeting, the setting up of a
flexible budget is most appropriate budget to be discussed.
The essence of a flexible budget is the presentation of the estimated
cost data in a manner that permits their determination at various levels
of volume. This means that all costs must be identified as to how they
behave with a change in volume – whether they vary or remain fixed.
The conceptual framework of flexible budgeting, therefore, relates to :
(i) Measure of volume and (ii) Cost behavior identified with change in
volume.

31. Example:
Capacity worked 50%
Fixed Costs: (Rs.) (Rs.)
Salaries 84000
Rent and rates 56000
Depreciation 70000
Other Administrative Exp. 80000 290000
Variable Costs:
Materials 240000
Labor 256000
Other Expenses 38000 534000
Possible sales at various levels of working are:
Capacity (%)
Sales
(RS.)
60 950000
75 1150000
90 1375000
100 1525000
Prepare a flexible budget and show the forecast of profit at
60%, 75%, 90% and 100% capacity operations.

32. Solutions:
Flexible Budget
% of 60% 75% 90% 100%
of Capacity
worked (Rs.) (Rs.) (Rs.) (Rs.)
Sales 950000 1150000 1375000 1525000
Less: Costs
Variable Costs:
Materials 288000 360000 432000 480000
Labour 307200 384000 460800 512000
Other Exp. 45600 57000 68400 76000
(A) Total Variable
Costs 640800 801000 961200 1068000
Fixed costs:
Salaries 84000 84000 84000 84000
Rent and Rates 56000 56000 56000 56000
Depreciation 70000 70000 70000 70000
Other adm. Exp. 80000 80000 80000 80000
(B) Total Fixed Cost 290000 290000 290000 290000
Total Costs (A+B) 930800 1091000 1251200 1358000
Forecast Profits 19200 59000 123800 167000