Types of budget

chapter
contents
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11
learning outcomes
This chapter continues the syllabus sub-section entitled Medium-term planning and decision-
making. 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.
1 Fixed budgets
2 Flexible budgets
3 Activity-based budgeting
4 Rolling/continuous budgets
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The aims of budgeting include planning, facilitating control and providing motiv-
ation. 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 plan-
ning 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
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 elab-
orated 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 feed-
back 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.
This chapter, and the syllabus, is restricted to xed, exible, rolling/continuous and
activity-based budgeting systems. Incremental budgeting canscarcely 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
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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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.
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.
variance
The difference between a
planned, budgeted or
standard cost and the actual
cost incurred. The same
comparison may be made for
revenues.
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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 examin-
ation.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 produc-
tion 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 control-
lable 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 vari-
ance).Therefore, xed budgets are not really effective for control purposes.
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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.
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 Actual Variance Variance as per cent
of budget
Sales quantity 10,000,000 12,000,000 2,000,000 20 per cent

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

Revenue 500,000 600,000 600,000 0
Material costs 200,000 240,000 240,000 0
Contribution 300,000 360,000 360,000 0
Fixed cost 250,000 250,000 250,000 0
Prot 50,000 110,000 110,000 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.
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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.
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 Flexed budget Actual Variance
Sales quantity 10,000,000 12,000,000 12,000,000 0

Revenue 500,000 600,000 550,000 (50,000)
Material costs 200,000 240,000 230,000 10,000
Contribution 300,000 360,000 320,000 (40,000)
Fixed overheads 250,000 250,000 240,000 10,000
Prot 50,000 110,000 80,000 (30,000)
Sales volume variance (Original budget prot exed budget prot) 60,000
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.
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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.
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: 2 seats 4 seats 8 seats Total
Standard direct hours per canoe 5 8 14 n.a.
Budgeted output for the month 100 100 100 300
Actual output in the month 200 50 50 300
Required
Compare the budgeted and actual standard hours produced in the last month.
Answer
Type of canoe: 2 seats 4 seats 8 seats Total
Standard direct hours per canoe 5 8 14 n.a.
Budgeted output for the month (units) 100 100 100 300
Actual output in the month (units) 200 50 50 300
Budgeted output for the month (standard hours) 500 800 1,400 2,700
Actual output in the month (standard hours) 1,000 400 700 2,100
Variance (standard hours) 500 (400) (700) (600)
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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 Actual Variances
Units sold 10,000 11,000 1,000

Sales revenue 250,000 255,000 5,000
Costs:
Materials 45,000 48,600 (3,600)
Labour 60,000 71,400 (11,400)
Variable overhead 30,000 40,000 (10,000)
Production overheads 35,000 38,000 (3,000)
Selling overheads 15,000 13,000 2,000
Administration 20,000 21,000 (1,000)
Total costs: 205,000 232,000 (27,000)
Prot (loss) 45,000 23,000 (22,000)
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.
Original Budget Flexed budget Actual Variances
Units sold 10,000 11,000 11,000

Sales revenue 250,000 275,000 255,000 (20,000)
Variable costs:
Materials 45,000 49,500 48,600 900
Labour 60,000 66,000 71,400 (5,400)
Variable overhead 30,000 33,000 40,000 (7,000)
Total variable cost 135,000 148,500 160,000 (11,500)
Contribution 115,000 126,500 95,000 (31,500)
Fixed costs:
Production overheads 35,000 35,000 38,000 (3,000)
Selling overheads 15,000 15,000 13,000 2,000
Administration 20,000 20,000 21,000 (1,000)
Total xed costs 70,000 70,000 72,000 (2,000)
Prot (loss) 45,000 56,500 23,000 (33,500)
Sales volume variance Flexed budget prot less original budget prot 11,500
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 100,000

Sales revenue 500,000

Variable costs:
Materials 50,000
Labour 100,000
Variable overhead 20,000
Total variable cost 170,000
Contribution 330,000
Fixed costs:
Production overheads 150,000
Selling overheads 80,000
Administration 70,000
Total xed costs 300,000
Prot (loss) 30,000
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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.
theory into practice 11.1 continued
Answer
Angouleme Ltd Budget comparisons for the coming year
Volume assumption Original 90 per cent of 80 per cent of 110 per cent of
budget budget budget budget
Standard hours sold 100,000 90,000 80,000 110,000

Sales revenue 500,000 450,000 400,000 550,000
Variable costs:
Materials 50,000 45,000 40,000 55,000
Labour 100,000 90,000 80,000 110,000
Variable overhead 20,000 18,000 16,000 22,000
Total variable cost 170,000 153,000 136,000 187,000
Contribution 330,000 297,000 264,000 363,000
Fixed overhead:
Production overheads 150,000 150,000 150,000 150,000
Selling overheads 80,000 80,000 80,000 80,000
Administration 70,000 70,000 70,000 70,000
Total xed costs 300,000 300,000 300,000 300,000
Prot (loss) 30,000 (3,000) (36,000) 63,000
Sales volume variance 0 (33,000) (66,000) 33,000
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 canbe usedfor planning, andcontrol, by combining exible budgeting prin-
ciples with activity-based costing. However, it is critical to identify reliable service-
units (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 HP100 HP200 LP30 LP60
Budgeted output in the coming year (units) 3,000 8,000 2,500 4,800
Standard batch sizes (units) 15 20 5 15
Standard materials movements per batch 5 6 13 8
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.
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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.
theory into practice 11.2 continued
Product HP100 HP200 LP30 LP60 Total
Budgeted output in the coming year (units) 3,000 8,000 2,500 4,800
Standard batch sizes (units) 15 20 5 15
Budgeted batches 200 400 500 320
Standard materials movements per batch 5 6 13 8
Budgeted materials movements 1,000 2,400 6,500 2,560 12,460
5 Budgeted materials handling cost pool () 62,300
Standard materials movements per batch 5 6 13 8
5 Standard handling cost per unit 25 30 65 40
(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.
test your knowledge 11.3
What are the benets to an organisation of converting from an absorption costing
budgeting system to ABB?
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
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.
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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 environ-
ment 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 Insome organisations, particularly inthe public sector, the budget is not just part of
a control mechanism, it is a means of allocating funds toactivities. One of the pecu-
liar 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 incre-
mental 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 busi-
nesses 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 twelve-
month 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 mini-
mise 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 particu-
larly 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 contin-
ually 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 sub-
system, 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.
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CHAPTER SUMMARY
This chapter covers the three main alternatives to the
conventional xed budget, i.e. exible budgeting, activity-
based 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:
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;
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.
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 semi-
skilled 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 Basic Domestic High Capacity
Standard hours per unit 32 18 53
Budget output for the next week (units) 120 48 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.
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11.5 Joly Consulting Ltd had the following data for the month ending 30 September:
Budgeted sales 20,000 standard hours
Actual sales 16,000 standard hours
Budgeted consultant hours worked 20,000
Actual consultant hours worked 12,000
Standard contribution 10 per hour
Actual contribution 11 per hour
Budgeted xed overhead 170,000
Actual xed overhead 175,000
Calculate:
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. (6 marks)
(b) How an ABC system may be developed into activity-based budgeting. (6 marks)
(c) How ABB can benet the company. (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
Budget Actual Variances
Quantity produced (cubic metres) 1,000 1,150 150

Revenue 100,000 V 120,750 20,750
Costs:
Extraction fees 20,000 V 23,000 (3,000)
Wages & salaries of:
Production labour 20,000 V 24,150 (4,150)
Maintenance 2,000 1,950 50
Supervision 3,000 2,800 200
Management & administration 4,500 4,650 (150)
Total wages and salaries 29,500 33,550 (4,050)
Fuel, oil and spares for:
Saws 1,000 V 1,035 (35)
Tractors & winches 500 V 460 40
Vans & trucks 250 275 (25)
Total fuel, oil and spares 1,750 1,770 (20)
Expenses:
Production 1,250 V 1,495 (245)
Maintenance 1,500 1,550 (50)
Management & administration 2,300 2,890 (590)
Buildings 850 720 130
Total expenses 5,900 6,655 (755)
Depreciation:
Saws 400 V 460 (60)
Tractors & winches 1,500 V 1,725 (225)
Vans & trucks 2,500 2,500 0
Maintenance equipment 1,300 1,300 0
Ofce equipment & furniture 950 950 0
Total depreciation 6,650 6,935 (285)
Total costs 63,800 71,910 (8,110)
Prot (loss) 36,200 48,840 12,640
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. (6 marks)
(c) You have discovered that Phelan Forests Ltds maintenance expenses are semi-variable. The output gures and
maintenance expenses for January to May are:
Month Output Maintenance expenses
m
3

January 1,100 1,530

February 900 1,460
March 1,000 1,510
April 1,300 1,620
May 1,150 1,550
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Required
Use the High-Low Technique to estimate the variable maintenance expense per cubic metre of output and the xed
maintenance expense per month. (3 marks)
11.10 Redleaf plc manufactures portable gas heaters. The company produces three models:
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 DH OH IH
Output and sales (units) 4,000 5,800 1,900
Selling prices (per unit) 38.50 62.00 312.00
Direct materials (per unit) 12.40 23.30 112.00
Direct labour (per unit) 6.20 12.60 31.00
Variable selling costs 10 per cent of sales 15 per cent of sales 12 per cent of sales
Budgeted overheads and cost drivers for JulyDecember 200X
Activity: Cost pool Cost driver:
Purchasing 26,500 Components used
Storing raw materials 15,800 Components used
Forming 46,900 Panels produced
Painting 24,400 Panels produced
Assembly 32,780 Batches produced
Materials handling 19,200 Batches produced
Inspection 42,350 Units produced
Storing nished goods 27,700 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 (4 marks)
(b) The prot from each model after attribution of activity based costs (15 marks)
(c) The total prot after marketing and administration costs. (1 mark)
11.11
PelykonInternational (PI) offers its customers aninsurancescheme that, inreturnfor amonthly premium, provides amaintenance
andemergency repair servicefor their domestic appliances andsystems. PIs customers areofferedthree 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).
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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 3-star 2-star 1-star
Average number of customers during the next year 11,000 6,000 15,000
(ii) Standard numbers of visits per year made by service engineers to each category of customer are:
Service level 3-star 2-star 1-star
Standard number of service visits per customer p.a. 4 2 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 3-star 2-star 1-star
Standard premium per customer per month 40 25 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 3-star 2-star 1-star
Standard variable o/h cost per service engineer hour 16 10 4
(vii) Budgeted activity-based xed costs for the year ended 31 December are:
Activity:
Marketing and sales 256,000
Contract management administering customers service contracts 448,000
Call centre providing a telesales service for marketing and sales;
receiving emergency calls from customers; instructing service engineers
to make service visits to customers 352,000
Purchasing and stores providing the materials and parts required by
service engineers 284,000
Accounting and credit control 480,000
Personnel management and staff training recruiting and training
service engineers 426,000
Transport providing and maintaining the vehicles used by service
engineers 355,000
Required
Prepare a statement that sets out the:
(a) budgeted annual contribution made by each service level. (5 marks)
(b) budgeted annual prot made by each service level, after activity-based costs. (15 marks)
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