Accounting Essays - Budgeting in Business

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Budgeting in Business.

Structure: Introduction, analysis and conclusion

2. (a)+(b)

In any organisation, planning and control are the major activities and budgets are at the centre of these activities. Budgets are used as a management tool which supports planning, aids control of costs and decision making, motivation and communications. It is also used to evaluate the performance of the company.

Budgetary control is the method of establishing budgets for different departments giving responsibilities to individual managers and comparing actual results against expected results. Plans are made for the future, they are implemented and monitored to see whether they conform to the plan. For this to happen requires support, cooperation and motivation from the management and staff.

A budgeting system should ideally, allow for the goals of individuals and groups of people to correspond with the goals of the company overall. Objectives of the organsisation should not be imposed without consulting with employees. Authority which is accepted from the lower hierachial levels is more effective than imposed authority and this is more effective when achieving goals.

Senior management is able to impose different budgets on different departments however if the preparation of the budgets involves the employees at a lower level then acceptance of the budgets is more likely. Involving people makes them feel more part of the team resulting in increased motivation. People will be more motivated with increased participation and this in turn will encourage responsibility and initiatives. It is more beneficial to have a reward system (i.e promotions, salary increases, bonuses) consistent with the organisational control system. If they are not consistent, then employees may ignore the system and it will be seen as having little importance and this could effect the objectives of the company. Generally, people will work more efficiently and effectively is they have been given clear targets and objectives. Communicating effectively between employees is also a factor to ensuring a successful budget.

Thus, budgeting is a crucial part of control and planning. They allow there to be plans made for the future and the implementation of these plans. For this, it is required that all members of the company give full cooperation and support to the budgets.

For absorption costing, incorrect assessment of the labour hours used, the amount of material wastage not correctly accounted for will result in inaccuracies and errors for the calculation of OAR. Human errors such as incomplete paperwork, delays in completing paperwork, deliberate falsification of data to give a false impression would result in incorrect information for the management.

The Roles of Absorption Costing and Variable Costing in product costing and decision making

In a manufacturing business, one needs to calculate how much a product costs to make. This is required to set a selling price in order to recover the costs incurred and to make profit in order that the business keeps running.

Departments that provide services to the production department, but not involved directly in the production must have some means of recovering their costs. The cost of the service departments must be apportioned to the product department. These indirect costs are called overheads and they are absorbed or included into the total cost of the product. All costs are absorbed into production and there is no separation of fixed and variable costs. Proper records of expenses by other departments must be kept. After the overheads have been apportioned to the appropriate cost centres, the amount of overhead to be included into the cost of each unit needs to be calculated. This is done by means of overhead absorption rate (OAR) and there are a number of different methods of calculating it.

Absorption Costing does however have some problems such as that the OAR must be updated on a regular basis. They are calculated from budgeted information and therefore can change as the actual results will be different from the budgeted, thus leading to inaccuracies. Accurate information is required if management has to make the right decisions.

Choosing an incorrect unit of absorption base can also introduce errors. Also calculations are based on predicted levels of output and variations in levels of output can lead to over or under absorption of overheads.
Under and over absorption of overheads occurs when actual overhead costs are different from budgeted overheads. Over absorption means that the overheads charged to the cost of production are greater than the overheads actually incurred. Under absorption means that insufficient overheads have been included in the cost of production.

Management must use an absorption rate that provides a reasonably accurate estimate of overhead costs. The absorption base must reflect the activities in a given cost centre. In a labour intensive cost centre, direct labour hour basis is most appropriate. But nowadays, production is achieved by using large number of machines and using this method will introduce errors.

Machine hour basis is appropriate for a cost centre employing large number of machines.

Direct Wages basis is widely used. Because of the different rates paid to different employees, this can cause some errors.

Absorption costing is often used for profit reporting and must be used for financial accounting purposes.

When considering Marginal Costing there are two types of costs --- variable and fixed.

Variable costs are direct labour and materials etc, i.e. costs that vary with the level of activity. It increases proportionately with the level of production.

Fixed costs are those which do not vary with the level of activity, e.g. heating, lighting, rent etc. Now if same value of fixed costs are taken along with different values of variable costs (which represents different production levels) to calculate the unit cost, then we get different answers. To avoid this Marginal Costing is used to removes the fixed costs and uses the total variable costs to calculate unit cost.

Marginal cost is the variable cost of one unit of product. The contribution can be worked out which is sales revenue less variable costs.

Relevant information on costs and revenues are necessary to make decisions for the future. This involves choosing between alternatives available. By looking at the marginal cost, revenue and contribution of each of the alternatives and checking for any limiting factors which might be a constraint, a decision can be made to choose the alternative which maximises contribution.

The limiting factor is a binding constraint which prevents further expansion of the business. An e.g. of a limiting factor is the shortages of material, labour or time. When one limiting factor exists, then it makes sense to maximise contribution per unit of the limiting factor.

Marginal costing is used for making decisions on

  • Pricing - decrease or increase of selling price of a product. It can work out the absolute minimum price that can be charged which will still ensure that fixed costs are covered.
  • making decisions whether to make own product or buy from outside. The decision has to be based on costs involved. The cost comparison is between the marginal cost of manufacture and the price of buying.
  • decisions regarding use of scarce resources

It must be noted that marginal costing excludes fixed costs from stock valuations and thus this will impact the reported profit.


It is imperative that for any business to trade effectively and be able to grow, it needs to build up enough cash reserves. Therefore it is important to ensure cash movements, that is the timing of cash inflow and cash outflow, is managed in such a way that it results in an overall positive cashflow position.

It would advisable to keep business forecasts up-to-date. A monthly or quarterly cash flow forecast would be very useful as you can review it at a regular intervals to keep it under control at all times. This will help you to record actual figures and then compare these actual figures with the budget or plan. Any variances can be pin pointed and investigated further to keep proper control on costs.

Marginal costing allows decisions to be made on product cost as it can determine the selling price for a product. Important decisions as to whether to manufacture the product or purchase from elsewhere can also be made. Although marginal costing may report a higher profit than absorption costing in certain accounting periods, the total profit will be the same regardless of method used.

Absorption costing gives the total cost of the production of goods and so can allow the company to make long term decisions as the total revenue must cover the direct costs of the company as well as all the overheads. If the cost of the product is far greater than the revenue coming in, then the company can make the decision as to whether to increase the selling price or reduce the costs of the overheads to make the product cheaper to produce. However, any decisions made must take into account the fact that absorption costing relies on information from budgets and so may be inaccurate.


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