Essay: Importance Of Flexible Budgets, Overhead Allocation, Operating Cycle, And Costing System In Business Management.

Types of Budgets and their Importance in Evaluating Performance

Question 1

a)Explain, using examples, why it is essential to create and use flexible budgets when evaluating past performance of a profit centre which manufactures and sells a product. What might be the objective of such a performance evaluation.
b)When preparing a cash budget for a manufacturing business for the following year, there may be many other budgets that will need to be produced before the cash budget is completed. 
List three (3) other budgets that must be prepared at the same time or before the cash budget is prepared, and for each one, explain the likely timing of cash flows that will occur and how this will impact a cash budget.

c)Explain what is meant by the ‘operating cycle’ for a manufacturing business and how this differs from the ‘cash cycle’. How does understanding all of the elements of the operating and cash cycle help in managing working capital efficiently? In you answer, explain the ratios and data we use to analyse the efficiency of managing working capital. 

d)Accounting isn’t as important in the government organisations as it is in private enterprises, since the government does not have to worry about earning a profit. Do you agree? Explain.

e)What is the essential purpose of any costing system? Explain. 
Question 2

Wonder Products Pty Ltd builds beautiful things to order for customers. When quoting prices on jobs Wonder Products allocate manufacturing overheads on the basis of estimated machine hours to complete the job. They allocate administrative overhead costs on the basis of direct labour hours estimated to complete the job. 

Below is a budget for the current year showing budget total figures.

Budget for the year
Direct labour costs for the year  $537,600
Manufacturing overheads for the year 598,080
Administrative overheads for the year 695,520

Direct labour hours for the year   4,000
Total machine hours for the year 7,000

a) Calculate a manufacturing overheads allocation rate for Wonder Products.

b) Calculate an administrative overhead allocation rate for Wonder Products.

c) Bushy George has asked Wonder Products Pty Ltd to make an especially wonderful creation to his specifications that will require the following inputs: 

Direct materials     $19,000
Direct labour          750 hours
Machine usage     400 hours

Assuming a mark up of 40% on total costs, what price should be quoted to Bushy to build him this especially wonderful creation?

d) Why is it so important to carefully allocate overhead expenses when quoting on jobs or when generally deciding on prices? Discuss problems that are encountered with overhead allocation methods and alternative approaches that might be taken.

e) Why do companies use predetermined (budgeted) overhead allocation rates rather than using actual overhead costs in allocating overhead costs to units of product?

Answer 1.

• Financial budget is prepared to estimate the expenses for the year at the beginning of the period. This helps the company to know about the gap between the estimated and the actual data. The management of the company enquires the reason for the difference and take necessary actions in order to improve.

There are two types of budget: Fixed budget and flexible budget. In a fixed budget all the assumptions are made based on the output of the business. The output is also forecasted and therefore, it may differ from the assumption made. This is the main reason why flexible budget is preferred over fixed budget. The flexible budget helps to understand all the items present in the income statement based on the actual output (Horngren, Datar and Rajan, 2017).

 The following table are an example of fixed budget and flexible budget:

The actual output and the budgeted output may differ from each other and this is observed in the fixed budget.

The budgeted cost is in respect of actual number of units produced so that the company can identify the variation and know the reasons for it.

The flexible budget is considered to be more useful than the fixed budget because it helps in evaluating the cost and the profitability in depth.

• The cash budget is prepared by every company in order to the source of the cash generation and the application of this cash in the company. The main business of any company is to produce goods and sell them; therefore a sales budget and production budget is to be prepared. Three budgets that are required to be prepared before the cash budget are-

1. Sales Budget- Sales budget is prepared by the company to forecast the sale for a short period of time on a monthly or quarterly basis. It is prepared for a short period because of the dynamic nature of the economy. Sales is the main source of cash generation for the company and hence this information of cash inflow is necessary to prepare the cash budget
2. Production Budget- Goods are required to be produced in order to generate revenue. It is equally important to know how much goods a company should produce so that they are in adequate quantity. As there is a cash outflow during the production process it is important to prepare this budget prior to preparing cash budget.
3. Raw material budget-  The raw material requirement of the company is based on the number of units to be produced. Raw material are the main expense of the company and therefore, it is very important to maintain a material budget. Material budget helps to record the amount of cash drainage because of the purchase of raw material and hence it is also prepared before the prepararyion of the cash budget of the company.

 (c ) The most common feature of a cash cycle and an operating cycle is the management of the cash available and also its working capital. Operating cycle is the time in which includes the entire process which is conversion from resource to cash. The starting of the operating cycle starts from the procurement of raw material and ends with receiving the payment from the buyers whereas cash cycle can be explained by the cash outflow during the procurement of raw materials and ends with receiving payments.

The working capital ratio can be defined as the ratio between the current assets and the current liabilities of the company. Other various working capital ratios are Inventory turnover ratio, debtor turnover ratio, creditor turnover ratio.

(d.) I totally disagree with the statement that accounting is more important in the private organisations than the government organisations. Like private organisation, there are many people to whom the accounting information is useful for taking various economic decisions. These persons include investors, creditors, government officials and also the other citizens of the country. The government organisations are not only considered about earning profits that are also concerned about the satisfaction of people and also the economic development of the country so the accounting information is considered very important by the stakeholders.

(e.) A costing system deals with the procurement of resources needed to manufacture a product and the method of production. The information relating to the manufacture is provided to the management of the company which is helpful to take important decisions such as cost controlling and decisions regarding outsourcing. The management before taking any decision regarding a particular order analyses whether it will be profitable for the company or not. If this information is present with the management then they may take relevant steps to improve them. There may be an order which may involve huge cost and less profit, it will help the management to plan its activities accordingly. Most importantly, it will help the stakeholders of the company to stay updated with the accounts of the company (Paramasivan and Subramanian, 2009).

Answer 2.

• Calculation showing the manufacturing overhead allocation rate of Wonder Products.

Note: Manufacturing overhead are calculated as per the machine hour.

• Calculation of administrative overhead allocation rate for wonder products

 Note: Administrative overhead is calculated as per labour hours.

    (c ) Calculation of total cost:

Quoted price = Total cost + Profit margin.

(d.)  The indirect cost that are incurred to produce a product is known as Overhead cost. It forms a huge part of the total cost apart from the raw material cost. In the traditional method, overhead cost is allocated based on a single cost driver which is calculated for all the various activities that are taking place. This is incorrect because if there are numerous activities then there should be different cost drivers based on the activities. The activity based costing is adopted by most countries in order to get information relating to the cost of each unit and its breakup (Pillai, 2010).

In the above question different activities were based on different cost drivers like labour hours and machine hours. The cost of overhead is added along with the other direct cost in order to get the total cost.

(e) The reason for preferring predetermined overhead allocation rate than real overhead rate is the Time frame. The actual overhead that has been incurred is known by the company only when the work gets completed. It becomes difficult for the company to estimate the overhead and recover from the customers. Therefore, a predetermined rate is calculated and according to that the cost is recovered. It is however not necessary that the cost will be recovered correctly i.e. it is possible that there may be under absorption or over absorption. Therefore, the rate determined is not calculated as a long term view (Tulsian, 2006).

References:

Horngren, C., Datar, S. and Rajan, M. (2017). Horngren's cost accounting. Harlow, Essex, England: Pearson Education Limited.

Paramasivan, C. and Subramanian, T. (2009). Financial management. New Delhi: New Age International (P) Ltd., Publishers.

Pillai, R. (2010). Management accounting. [Place of publication not identified]: S Chand & Co Ltd.

Tulsian, P. (2006). Financial accounting. New Delhi: Pearson/Education.