08 - Budgeting

Question 1

What are the learning outcomes of the chapter on Budgeting?

Answer 1

• Explain why organisations set out financial plans in the form of budgets, typically for a financial year.
• Prepare functional budgets and budgets for capital expenditure and depreciatien.
• Prepare a master budget based on functional budgets.
• Explain budget statements.
• Identify the impact of budgeted cash surpluses and shortfalls on business operations.
• Prepare a flexible budget.
• Calculate budget variances.
• Distinguish between fixed and flexible budgets.
• Prepare a statement that reconciles budgeted contribution with actual contribution.

Question 2

What is the purpose of a budget?

Answer 2

Budgets have two main roles:

• They act as authorities to spend, that is, they give authority to budget managers to incur expenditure in their part of the organisation.
• They act as comparators for current performance by providing a yardstick against which current activities can be monitored.

These two roles are combined in a system of budgetary planning and control.

Question 3

What is planning and what are the benefits?

Answer 3

• Planning the activities of an organisation helps ensure that the organisation sets out in the right direction.
• Individuals within the organisation will have definite targets which they aim to achieve.
• Without a formalised plan, the organisation lacks direction and managers are not aware of their own targets and responsibilities.
• Neither do they appreciate how their activities relate to those of other managers within the organisation.
• A formalised plan will help ensure a coordinated approach.
• The planning process itself forces managers to continually think ahead, planning and reviewing their activities in advance.

Question 4

What forms of planning exist?

Answer 4

Term

• There are three forms of planning and they are all interrelated.
• The main distinction between them relates to their time span which may be:
  
  • short term
  • medium term
  • or long term.
• The short term for one organisation may be the medium or long term for another, depending on the type of activity in which it is involved.

Forms

• Strategic
  
  • Strategic planning is concerned with preparing long-term action plans to attain the organisations objectives
  • Also known as corporate planning or long-range planning.
• Budgetary
  
  • Budgetary planning is concerned with preparing short- to medium-term plans of the organisation.
  • It is carried out within the framework of the strategic plan.
  • An organisations annual budget could be seen as an interim step towards achieving the long-term or strategic plan.
• Operational
  
  • Operational planning refers to the short-term or day-to-day planning process.
  • It is concerned with planning the utilisation of resources and will be carried out within the framework set by the budgetary plan.
  • Each stage in the operational planning process can be seen as an interim step towards achieving the budget for the period.

Question 5

What is control and how does it relate to planning?

Answer 5

The budgetary process should not stop with the plan.

Once the organisation has started out in the right direction it is the management’s responsibility to exercise control that will ensure that it continues on course.

Control is best achieved by comparison of the actual results with the original plan.

Appropriate action can then be taken to correct any deviations from the plan.

The comparison of actual results with a budgetary plan, and the taking of action to correct deviations, is known as feedback control.

Question 6

How are activities of planning and control related?

Answer 6

The two activities of planning and control must go hand in hand.

Carrying out the budgetary planning exercise without using the plan for control purposes is performing only part of the task.

The full benefit of any planning exercise is not realised unless the plan is also used for control purposes.

Each of the types of planning should be accompanied by the appropriate control exercise covering the same time span.

Question 7

What is a budget?

Answer 7

A budget is a quantitative expression of a plan for a defined period of time.

It may include planned sales volumes and revenues, resource quantities, costs and expenses, assets, liabilities and cash flows.

Question 8

Why must budgets be quantified?

Answer 8

For a budget to be useful it must be quantified.

The quantification of the budgets has provided:

• A definite target for planning purposes.
• A yardstick for control purposes.

Question 9

What is the budget period?

Answer 9

The time period for which a budget is prepared and used is called the budget period.

It can be any length to suit management purposes but it is usually one year.

The length of time chosen for the budget period will depend on many factors, including:

• the nature of the organisation
• and the type of expenditure being considered.

Each budget period can be subdivided into control periods, also of varying lengths, depending on the level of control which management wishes to exercise.

The usual length of a control period is one month.

Question 10

What is the principal budget factor?

Answer 10

The principal (key) budget factor is the factor which limits the activities of the organisation and is also therefore known as the limiting factor.

The early identification of this factor is important in the budgetary planning process because it indicates which budget should be prepared first.

Failure to identify the principal budget factor at an early stage could lead to delays at a later stage when managers realise that the targets they have been working with are not feasible.

Example

• For example, if sales volume is the principal budget factor, the sales budget must be prepared first, based on the available sales forecasts.
• All other budgets should then be linked to this.
• Similarly, machine capacity may be limited for the forthcoming period and therefore machine capacity is the principal budget factor.
• In this case, the production budget must be prepared first and all other budgets must be linked to this.

Question 11

Why is the principal budget factor of critical importance?

Answer 11

The critical importance of the principal budget factor stems from the fact that all budgets are interrelated.

Example

For example, if sales is the principal budget factor this is the first budget to be prepared.

This will then provide the basis for the preparation of several other budgets including the selling expenses budget and the production budget.

However, the production budget cannot be prepared directly from the sales budget without a consideration of inventory policy.

For example, the management may plan to increase finished goods inventory in anticipation of a sales drive.

Production quantities would then have to be higher than the budgeted sales level.

Similarly, if a decision is taken to reduce the level of material inventories held, it would not be necessary to purchase all of the materials required for production.

Question 12

What is the consequence of budgets being interrelated?

Answer 12

The interrelationship between budgets means that the need for coordination in the planning process is paramount.

The best way to achieve this coordination is to set up a budget committee.

The budget committee should:

• comprise representatives from all functions in the organisation.
• meet regularly to review the progress of the budgetary planning process and to resolve problems that have arisen.

These meetings will effectively bring together the whole organisation in one room, to ensure a coordinated approach to budget preparation

Question 13

What is a master budget?

Answer 13

Defintion

The master budget consolidates all subsidaiary budgets and is normally comprised of the

• budgeted Statement of profit or loss,
• Statement of financial position
• and cash flow statement.

Other

It is this master budget which is submitted to senior managers for approval because they should not be burdened with an excessive amount of detail.

The master budget is designed to give the summarised information that they need to determine whether the budget is an acceptable plan for the forthcoming period.

Question 14

What is participative budgeting?

Answer 14

Definition

Participative budgeting is a budgeting process where all budget holders have the opportunity to participate in setting their own budgets.

Other

Participative budgeting may also be referred to as bottom-up budgeting.

It contrasts with imposed or top-down budgets where the ultimate budget holder does not have the opportunity to participate in the budgeting process.

Question 15

What are the advantages and disdvantages of participative budgeting?

Answer 15

Advantages

• Improved quality of forecasts
  
  • Better quality forecasts can be used as the basis for the budget.
  • Managers who are doing a job on a day-to-day basis are likely to have a better idea of what is achievable, what is likely to happen in the forthcoming period, local trading conditions, etc.
• Improved motivation
  
  • Budget holders are more likely to want to work to achieve a budget that they have been involved in setting themselves, rather than one that has been imposed on them by more senior managers.
  • They will own the budget and accept responsibility for the achievement of the targets contained therein.

Disadvantages

• The main disadvantages of participative budgeting is that it tends to result in a more extended and complex budgetary process and can lead to budgetary slack.
• However, the advantages are generally accepted to outweigh this.

Question 16

Why are computers used in the budgetary planning process?

Answer 16

A vast amount of data is involved in the budgetary planning process.

Managing this volume of data in a manual system is an onerous and cumbersome task.

A computerised budgetary planning system will have the following advantages over a manual system:

• Computers can easily handle the volume of data involved.
• A computerised system can process the data more rapidly than a manual system.
• A computerised system can process the data more accurately than a manual system.
• Computers can quickly and accurately access and manipulate the data in the system.

Question 17

What software is used for budgeting puropses?

Answer 17

Organisations may use specially designed budgeting software.

Alternatively, a well-designed spreadsheet model can take account of all budget interrelationships.

• The model should contain variables for all of the factors about which decisions must be made in the planning process, for example, sales volume, unit costs, credit periods and inventory volumes.
• If managers wish to assess the effect on the budget results of a change in one of the decision variables, this can be accommodated easily by amending the relevant variable in the spreadsheet model.
• The effect of the change on all of the budgets will be calculated instantly so that managers can make better informed planning decisions.

Question 18

Are budgets a once-off activity?

Answer 18

Budgetary planning is an iterative process.

Once the first set of budgets has been prepared, those budgets will be considered by senior managers.

The criteria used to assess the suitability of budgets may include adherence to the organisation’s:

• long-term objectives
• profitability
• and liquidity.

Computerised spreadsheet models then provide managers with the ability to amend the budgets rapidly, and adjust decision variables until they feel that they have achieved the optimum plan for the organisation for the forthcoming period.

‘What if’ analysis

This process of reviewing the effect of changes in the decision variables is called ‘what-if?’ analysis.

For example, managers can rapidly obtain the answer to the question, What if sales volumes are 10% lower than expected?

Question 19

What is a budget manual?

Answer 19

Effective budgetary planning relies on the provision of adequate information to the individuals involved in the planning process.

Many of these information needs are contained in the budget manual.

A budget manual is a collection of documents which contains key information for those involved in the planning process.

Question 20

What is included in the budget manual?

Answer 20

• Introduction
  
  • Budget manual begins with an introductory explanation of the budgetary planning and control process includin a statemetn of the budgetary objective and desired results.
  • Participants should be made aware of the advantages of an efficient planning and control process to them and to the organisation.
  • This introduction should give participants an understanding of the works of the planning process and of the sort of information that they can expect to receive as part of the control process.
• Organisation chart
  
  • A form of organisation chart shows who is responsible for the preparation of each functional budget and the way in which the budgets are interrelated.
• Timetable
  
  • A timetable for the preparation of each budget.
  • This will prevent the formation of a ‘bottleneck’, with the late preparatoin of one budget holding up the preparation of all others.
• Forms
  
  • Copies of all forms to be completed by those responsible for preparing budgets, with explanations concerning their completion.
• Account codes
  
  • A list of the organisation’s account codes, with full explanations of how to use them.
• Key assumptions
  
  • Information concerning key assumptions to be made by managers in their budgets
  • E.g. the rate of inflation, key exchange rates, etc.
• Budget Officer
  
  • The name and location of the person to be contacted concerning any problems encountered in preparing budgetary plans.
  • This is usually the co-ordinator of the budget committe (the budget officer) and will probably be a senior accountant.

Question 21

What is Feedforward control?

Answer 21

Definition

Feedforward control is the forecasting of differences between actual and planned outcomes, and the implementation of action, before the event, to avoid such differences.

Question 22

What is the cash budget?

Answer 22

The cash budget is one of the most vital planning documents in an organisation.

It will show the cash effect of all of the decisions taken in the planning process.

Management decisions will be taken concerning such factors as inventory policy, credit policy, selling price policy and so on.

All of these plans will be designed to meet the objectives of the organisation.

However, if there are insufficient cash resources to finance the plans they may need to be modified or perhaps action might be taken to alleviate the cash restraint.

Question 23

What is the resulting action from a cash budgeting exercise?

Answer 23

A cash budget can give forewarning of potential problems that could arise so that managers can be prepared for the situation or take action to avoid it.

There are four possible cash positions that could arise:

• Short-term deficit
  
  • Arrange a bank overdraft, reduce receivables and inventories, increase payables
• Long-term deficit
  
  • Raise long-term finance, such as long-term loan capital or share capital
• Short-term surplus
  
  • Invest shortterm, increase receivables and inventories to boost sales, pay suppliers early to obtain cash discount
• Long-term surplus
  
  • Expand or diversify operations, replace or update non-current assets

The type of action taken by the management will depend not only on whether a deficit or a surplus is expected, but also on how long the situation is expected to last.

For example, the management would not wish to use surplus cash to purchase non-current assets if the surplus was only short term and the cash would soon be required again for day-to-day operations.

Cash budgets therefore forewarn managers of whether there will be cash surpluses or cash deficits and how long the surpluses or deficits are expected to last.

Question 24

What are the principles to be followed when preparing cash budgets?

Answer 24

• The format for cash budgets
• Depreciation is not included in cash budgets
• Allowance must be made for bad and doubtful debts

Question 25

Cash budget principle: The format for cash budgets

Answer 25

There is no definitive format which should be used for a cash budget.

However, whichever format you decide to use it should include the following:

• A clear distinction between the cash receipts and cash payments for each control period. Your budget should not consist of a jumble of cash flows. It should be logically arranged with a subtotal for receipts and a subtotal for payments.
• A figure for the net cash flow for each period. It could be argued that this is not an essential feature of a cash budget. However, you will find it easier to prepare and use a cash budget if you include the net cash flow. Also, managers find in practice that a figure for the net cash flow helps to draw attention to the cash flow implications of their actions during the period.
• The closing cash balance for each control period will be the opening balance for the following period.

Question 26

Cash budget principle: Depreciation is not included in cash budgets

Answer 26

Remember that depreciation is not a cash flow. It may be included in your data for overheads and must therefore be excluded before the overheads are inserted into the cash budget.

Question 27

Cash budget principle: Allowance must be made for bad and doubtful debts

Answer 27

Bad debts will never be received in cash and doubtful debts may not be received.

When you are forecasting the cash receipts from customers you must remember to adjust for these items, if necessary.

Question 28

What are rolling budgets?

Answer 28

Definition

A rolling budget is a budget that is continuously updated by adding a further accounting period (month or quarter) when the earliest accounting period has expired.

Its use is particularly beneficial where future costs and/or activities cannot be forecast accurately.

Example

For example, a budget may initially be prepared for January to December, year 1. At the end of the first quarter, that is, at the end of March, year 1, the first quarter’s budget is deleted. A further quarter is then added to the end of the remaining budget, for January to March, year 2. The budget after the first quarter is updated in the light of current conditions. This means that managers have a full year’s budget always available and the rolling process forces them continually to plan ahead.

Question 29

What functions do budgets perform?

Answer 29

Budgets are created to perform the following functions:

• To act as authorities that spend, that is, to give authority to budget managers to incur expenditure in their part of the organisation.
• To act as comparators for current performances by providing a yardstick against which current activities can be monitored.

Budgets thus perform both operating and non-operating functions. A budget should not be seen as a one-off event.

Question 30

When are rolling budgets required?

Answer 30

It is not necessary for all of the budgets in a system to be prepared on a rolling basis.

For example, many organisations will use a rolling system for the cash budget only.

In practice, most organisations carry out some form of updating process on all their budgets so that the budgets represent a realistic target for planning and control purposes.

The formalised budgetary planning process will still be performed on a regular basis to ensure a coordinated approach to budgetary planning.

Question 31

How are budgets for non-operating functions created?

Answer 31

Most operating budgets can be linked to, and coordinated with, non-operating budgets once the principal budget factor has been identified and budgeted. The level of expenditure is thus directly linked to the level of activity.

Budgets for non-operating functions such as computer services and research and development are only indirectly linked to activity levels. Determining the level of expenditure to be included in these non-operating budgets is not quite so straightforward.

Methods

• Budgets using the incremental budeting approach are called incremental budgets. The incremental budget is based on the budget or actual results for the previous period, adjusting for any expected changes and inflation. The incremental budget has ben found to have several drawbacks
  
  • Efficient allocation of resources
  • Managers forced to consider alternative ways of achieving objectives
  • Managers required to justify activities
  • Elimination or reduction of budget slack
• Budgets using the zero-based budgeting (ZBB) approach are called zero-based budgets. The zero-based budget is justified from zero. It requires all costs to be justified by the expected benefits. Incremental levels of expenditure on each activity are evaluated according to the resulting incremental benefits. Zero-based budgets were developed as an alternative to incremental budgets because of several drawbacks:
  
  • Inefficient allocation of resources
  • Perpetuation of inefficient and unnecesssary practices
  • Budget slack: intentional overestimation or underestimation of revenues in the budgeting process.

Question 32

How are budgets used for control purposes?

Answer 32

Budgets are used for control purposes to ensure that the organisation continues in the right direction.

Budgetary control is achieved by comparing the actual results with the budget.

The differences are calculated as variances and management action may be taken to investigate and correct the variances if necessary or appropriate.

Variances are either adverse or favourable.

Question 33

What is a budget centre?

Answer 33

Definition

A budget centre is a section of an entity for which control may be exercised through prepared budgets.

Other

Each budget centre is often a responsibility centre.

Each centre will have its own budget and a manager will be responsible for managing the centre and controlling the budget. This manager is often referred to as the budget holder.

Regular budgetary control reports will be sent to each budget holder so that they may monitor their centre’s activities and take control action if necessary.

Question 34

Budget characteristics

Answer 34

• Timely - The information should be made available as soon as possible.
  
  • The information should be made available as soon as possible after the control period.
  • Corrective action will be much more effective if it is taken soon after the event and adverse trends could continue unchecked if budgetary reporting systems are slow.
• Accurate - The information should be precise and correct.
  
  • Inaccurate control information could lead to inappropriate management action.
  • There is often a conflict between the need for timeliness and the need for accuracy.
  • More accurate information might take longer to produce.
  • The design of budgetary reporting systems should allow for suffiicent accuracy for the purpose to be fulfilled.
• Relevant to the recipient - The information should be specific to the need of the respective budget holder.
  
  • Busy managers should not be swamped with information that is not relevant to them.
  • They should not need to search through a lot of irrelevant information to reach the part which relates to their area of responsibility.
  • The natural reaction of managers in this situation could be to ignore the information altogether.
• Communicated to the correct manager - The information should be directed to the concerned authority only.
  
  • Control information should be directed to the manager who has the responsibility and authority to act upon it.
  • If the information is communicated to the wrong manager, its value will be immediately lost and any adverse trends may continue uncorrected.
  • Individual budget holders’ responsibilities must be clearly defined and kept up-to-date in respect of any changes.

Question 35

What is the exception principle?

Answer 35

The budgetary reporting system should ideally be based on the exception principle which means that management attention is focused on those areas where performance is significantly different from budget.

Subsidiary information could be provided on those items which are in line with the budget.

Many control reports also segregate controllable and non-controllable costs and revenues, that is, the costs and revenues over which managers can exercise control are highlighted separately in the reports from those over which they have no control.

A number of accounting packages have the facility to record acutal and budget details against each account code for each budget centre. These may then be printed in the form of a report.