Question

Budgets and Standard Costing: Evaluate the different types of budgets and discuss how operating and financial budgets are prepared for a manufacturing company. Discuss the use of budgets and standard costs to control business activities. Explain how standard costs are used to determine variances.

Answer 1

Step 1 : Different types of Budgets

The most common budget types includes the following:-

a) Master Budget : It is the set of operating and financial budgets for a specific accounting period, usually the next fiscal or calender year.

b) Operating Budget : It is the budget for income statement elements such as revenues and expenses.

c) Financial Budget : It is the budget for balance sheet elements. It deals with the expected assets, liabilities and stockholder's equity.

d) Cash Budget : It is the budget for expected cash inflows and outflows during the specific period of time.

e) Static Budget : It is also called Fixed Budget. It is the budget expected at the capacity level. Because static budget is fixed, it is usually used by Stable companies.

f) Flexible Budget : It is the budget at the actual capacity level. Because flexible budget is dynamic, it is commanly used by companies.

g) Capital Expenditure Budget : It is the budget for expected investments in capital assets and long term projects. It is usually prepared for 3 to 10 years.

h) Program Budget : It is the budget for a specific program or activity such as marketing, research and development, public relations, training, engineering etc.

Step 2 : Preparation of Operating and Financial budgets for a manufacturing company

Budgeting is the company's tool for both planning and control. Operational Budget consists of eight elements : Sales budget, Production Budget, Ending inventory budget, Direct materials budget, Direct Labor budget, Factory overhead budget, Selling and administrative expense Budget and Proforma Income Statement.

Financial Budget consist of cash budget and Proforma Balance Sheet.

The major steps in preparing the budget are:-

1. Preparing a sales forecast or sales budget.
2. Determining production volume (Production Budget).
3. Estimating manufacturing costs and operating expenses (Direct Material, Direct Labor and factory Overhead Budget).
4. Determining cash flow and other financial effects (The cash Budget).
5. Formulation of Projected Financial Statements (Budgeted Income Statement and Balance Sheet).

Step 3 : Use of budgets and standard costs to control business activities

A budget sets standards to indicate the level of activity expected from each responsible person or decision unit, and the amount of resources that a responsible party should use in achieving that level of activity. A budget establishes the responsibility center, delegates the responsibilities, and determines the decision points within an organization. Standard cost determines variances between the actual and estimated activities and helps in controlling those activities in future.

Step 4 : Determination of variances in Standard costing

Standard costing involves the creation of estimated costs for some or all activities within a company. A variance is the difference between the actual cost incurred and the standard cost against which it is measured. A variance can also be used to measure the difference between actual and expected sales. Variance analysis can be used to review the performance of both revenues and expenses.