CHAPTER- SIX

6.Preparation of Operating Budgets

The operating budget is a detailed statement showing all the operational expenses to be incurred and
incomes to be generated during a particular period of time. Operating expenses such as expenses on
raw material purchases, processing cost, interest on a loan, the salary of the staff, maintenance of the
office, administrative expense is considered for the purpose of operating budget. The operating
income such as revenue from operations and income by sale of the by-product is considered for the
purpose of operating budget.

Depending on the size, structure, and nature of the organization, operating budget may be sub-divided
for the purpose of detailed understanding of the budget.

operating Budget is prepared by considering many factors and assumptions. Below are some of the
factors which are used for preparing a budget for the organization.

a. Past trend in sales

1. Past trends of the purchase price of the raw material
2. Changes in the tax laws and government regulation with respect to the
industry
3. Overall economy
Based on the above factors, sales or income budget is developed at first. The reason is all the
expenses shall be based on the sales projection made by the organization.
Once the budget for sales or income is developed, the expense budget is prepared. The expenses have
to be estimated based on the sales and the past trends in the tax regulations, interest rates on
borrowing. There are three types of expenses;

a. Variable cost – these cost changes with the change in sales.

b. Fixed cost – the fixed overheads which remain fixed such as rent of factory or machinery is fixed
irrespective of the production.
c. Semi-variable cost – these are the cost which is fixed for certain level. However, it becomes
variable after reaching a certain point. For example, a minimum wage of the marketing staff is USD
2,000 and if the sales increase above a certain limit, the commission shall be based on a percentage of
sales.
Financial Accounting helps in developing the operating budget in many ways.

COMPILED BY WENDOSEN .H (2020/21) 1

1.1 . Cost Estimation
Cost estimating is the predictive process used to quantify, cost, and price the resources
required by the scope of the project, to better manage budgets and deliver projects that do
not exceed the identified scope, and that are on time throughout the development process.
The need to solidify the estimation process can be seen in four areas:
1. State financial plan
2. Creation of public satisfaction and a positive response
3. Project control
4. Problems currently being encountered
The state financial plan is affected as cost estimates are used to obtain and allocate
funding for the overruns of the estimated project costs. This leads to the second reason for
the need for cost estimates: influencing public opinion.
Public satisfaction is increased if transportation projects show and prove to the general
public that they are timely and within budget. Public declaration of the estimated cost of
projects needs to be thoughtfully provided only after care is taken to produce a well-
documented, quality estimate.
Project control relies on cost estimates to help keep projects within the appropriate fiscal
boundaries. Although not necessarily a “check and balance” format, the existence of the
original estimate will keep the project from growing and expanding beyond its spending
limit.
As projects encounter problems, and their estimates come “under fire,” great scrutiny is
given to the project and its associated estimates. The ability to confront and solve problems
and obstacles relies in large part on the quality of the estimate and the documentation,
which, if done properly, will provide critical support to project.

The sequence of estimates throughout the life of a typical project is given below.
1. Preliminary
The quick estimate needed at the project identification stage, with no design available,
and only the barest statement of capacity or size.
2. Feasibility
Estimates or alternative schemes under consideration in the feasibility study stage of
the project. The essential property of these estimates is that they are directly comparable
with each other and therefore base estimates could suffice so long as the same
estimating technique and price base data are used.
 3. Design
The cost estimate for the selected scheme using the design (usually conceptual) and
specifications resulting from the design study and forming part of the project definition
report. This estimate would provide the figures for capital cost, cash flow and currency
requirements which would then be used in viability calculations for the project and in
the submission for donor aid, where appropriate. It must be a cash estimate.
4. Commitment
The proposal estimates as modified and approved for financing, together with the
associated modifications to the project definition and/or the program. This must be a
cash estimate, and will provide the basis for the cost control of the project.
5. Pre-tender
A refinement of the approved estimate in the light of further design work done during
the tender period and using the information given in the enquiry documents. This
estimate therefore would use the same information as is available to the tendering
contractors and should be a good
basis for the assessment of bids.
6. Post contract award
A further refinement of the approved estimate in the light of the contract(s) awarded. It
includes redistribution of the monies within the approved total to allow more effective
cost monitoring of the project to completion.
7. Achieved cost
A record of the actual costs achieved in order to review the cost performance of the
project and for project evaluation. It should include a reconciliation of the actual use of
contingencies and of the use of tolerance for dealing with major risks.
THE ESTIMATOR
1. The estimator must have relevant experience in the type of project envisaged and,
wherever possible, in the costs and productivities of construction work at the proposed
construction and main supply locations.
2. The estimator must have a close working relationship with the project design
organization and will normally be part of that organization.
3. . It is highly desirable that the same estimator is used on all the estimates required
during the life of the project and is responsible for the subsequent cost monitoring and
control.
 4. The estimator should be accountable for his estimate and should be involved in
the subsequent monitoring of project costs against it. He should be responsible success.
6.2 Cost Allocation => Crosswalk

Cost allocation is the process of identifying, accumulating, and assigning costs to costs
objects such as departments, products, programs, or a branch of a company. It involves
identifying the costs objects in a company, identifying the costs incurred by the cost objects,
and then assigning the costs to the cost objects based on specific criteria.
When costs are allocated in the right way, the business is able to trace the specific cost
objects that are making profits or losses for the company. If costs are allocated to the wrong
cost objects, the company may be assigning more resources to cost objects that do not yield
as much profits as expected.
Types of Costs

There are several types of costs that an organization must define before allocating costs to
their specific cost objects. These costs include:

1. Direct costs

Direct costs are costs that can be attributed to a specific product or service, and they do not
need to be allocated to the specific cost object. It is because the organization knows what
expenses go to the specific departments that generate profits and the costs incurred in
producing specific products or services. For example, the salaries paid to factory workers
assigned to a specific division is known and does not need to be allocated again to that
division.

2. Indirect costs

Indirect costs are costs that are not directly related to a specific cost object like a function,
product, or department. They are costs that are needed for the sake of the company’s
operations and health. Some common examples of indirect costs include security costs,
administration costs, etc. The costs are first identified, pooled, and then allocated to specific
cost objects within the organization.
Indirect costs can be divided into fixed and variable costs. Fixed costs are costs that are fixed
for a specific product or department. An example of a fixed cost is the remuneration of a
project supervisor assigned to a specific division. The other category of indirect cost is
variable costs, which vary with the level of output. Indirect costs increase or decrease with
changes in the level of output.

3. Overhead costs

Overhead costs are indirect costs that are not part of manufacturing costs. They are not
related to the labor or material costs that are incurred in the production of goods or services.
They support the production or selling processes of the goods or services. Overhead costs are
charged to the expense account, and they must be continually paid regardless of whether the
company is selling any good or not.
Some common examples of overhead costs are rental expenses, utilities, insurance, postage
and printing, administrative and legal expenses, and research and development costs.

Cost Allocation Mechanism

The following are the main steps involves when allocating costs to cost objects:

1. Identify cost objects

The first step when allocating costs is to identify the cost objects for which the organization
needs to separately estimate the associated cost. Identifying specific cost objects is important
because the organization cannot allocate costs to something that is not yet known.
The cost object can be a brand, project, product line, division/department, or a branch of the
company. The company should also determine the cost allocation base, which is the basis that
it uses to allocate the costs to cost objects.

2. Accumulate costs into a cost pool

After identifying the cost objects, the next step is to accumulate the costs into a cost pool,
pending allocation to the cost objects. When accumulating costs, you can create several
categories where the costs will be pooled based on the cost allocation base used. Some
examples of cost pools include electricity usage, water usage, square footage, insurance, rent
expenses, fuel consumption, and motor vehicle maintenance.
What is a Cost Driver?

A cost driver causes a change in the cost associated with an activity. Some examples of cost
drivers include the number of machine-hours, the number of direct labor hours worked, the
number of payments processed, the number of purchase orders, and the number of invoices
sent to customers.

Benefits of Cost Allocation

The following are some of the reasons why cost allocation is important to an organization:

1. Assists in the decision-making process

Cost allocation provides the management with important data about cost utilization that they
can use in making decisions. It shows the cost objects that take up most of the costs and helps
determine if the departments or products are profitable enough to justify the costs allocated.
For unprofitable cost objects, the company’s management can cut the costs allocated and
divert the money to other more profitable cost objects.

2. Helps evaluate and motivate staff

Cost allocation helps determine if the cost assigned to specific departments returns the
expected revenues. If the cost object is not profitable, the company can evaluate the
performance of the staff members to determine if a decline in productivity is the cause of the
non-profitability of the cost objects.
On the other hand, if the company recognizes a specific department as the most profitable
department in the company, the employees assigned to that department will be motivated to
work hard and stay ahead of the rest in terms of performance.