7.1 Preparing budgets

Question 1

A budget is a

Answer 1

• Quantitative or financial plan relating to the future
• It can be for the company as a whole or for departments, functions, products or for resources
• It is usually for one year or less

Question 2

Purposes of budgeting

Answer 2

• Planning
• Control and evaluation
• Coordination
• Communication
• Motivation
• Authorisation

Question 3

Purpose of budgeting - Planning

Answer 3

• The budgeting process forces management to look ahead, set targets, anticipate problems and give the org purpose and direction
• Decisions will be based on reasoned judgements
• Long term strategies are converted into shorter term action plans

Question 4

Purpose of budgeting - Control and evaluation

Answer 4

• It provides the plan against which actual results can be compared
• Results that are out of line can be further investigated and corrected
• Performance of management can be evaluated by measuring their success in achieving budgets

Question 5

Purpose of budgeting - Coordination

Answer 5

• It brings together the actions of the different parts of an org and reconciles them into a common plan
• Without guidance managers could make their own decisions which may not be in best interests of the org
• It helps to coordinate the different activities and ensure they are in harmony with each other

Question 6

Purpose of budgeting - Communication

Answer 6

• They communicate targets to managers
• It communicates the expectations of top level (strategic) management to lower level (operational and tactical) management
• This allows all members of the org to understand the expectations and coordinate their activities to attain them

Question 7

Purpose of budgeting - Motivation

Answer 7

• It can be a useful device for influencing managerial behaviour and motivating managers to perform in line with the org objectives

Question 8

Purpose of budgeting - Authorisation

Answer 8

• It may act as formal authorisation to a manager for expenditure, the hiring of staff and the pursuit of the plans contained in the budget

Question 9

Advantages of budgeting

Answer 9

• They ensure the org actions are matched to it’s goals and that these goals are communicated throughout the org
• It forces management to consider the future and how the bus environment (internal and external) might change
• The org will be better placed to cope with change and they can act as an early warning system for problems
• Forces management to consider the cost and profitability of products, departments, functions, etc
• And forces them to consider the value added by these products, departments or functions
• Improves decisions on resources and cash allocation, financing and investment
• Facilitates performance evaluation in areas such as the use of variance analysis

Question 10

Disadvantages of budgeting

Answer 10

• It can be time consuming for staff and management and may distract from the bus core operations
• Predicting future changes is very subjective and relies on the ability of the preparer to make these predictions as accurately as possible
• They can create conflicts and barriers between budget holders rather than knowledge sharing and coordination
• The use of budgets can encourage short termism where discretionary expenditure (eg staff training) is reduced in order to meet budget targets
• They focus on financial outcomes rather than broader measures of success such as customer satisfaction, quality, etc
• It could encourage managers to spend what is in budget even if not necessary to avoid reductions in next years budget
• Can deter innovation and enterprise as staff become focused on meeting the targets rather than exceeding them or responding to changing market needs

Question 11

Functional budgets

Answer 11

In a manufacturing org the budgeting process will probably consist of preparing several functional budgets, beginning with a sales budget (all for the same period)

Question 12

A master budget is a

Answer 12

• Summary of all the functional budgets
• Comprises the budgeted statement of profit or loss, budgeted statement of financial position and cash budget
• This is submitted to senior management for approval

Question 13

Key factor / Principal budget factor (aka limiting budget factor)

Answer 13

• Key factor is normally assumed to be sales demand which limits what the org can expect to achieve in the budget period
• A principal budget factor is a key resource that is in short supply and affects the planning decisions
• This will be starting point for all other budgets

Question 14

Budget preparation stages:

Answer 14

Step 1 - Sales budget
Step 2 - Production budget
Step 3 - Cost of goods sold budget (raw materials, labour, factory overhead)
Step 4 - Selling and distribution expenses budget & General and administration expenses budget
Step 5 - Master Budget - Budgeted statement of profit
Step 6 - Cash budget ( Capital expenditure budget)
Step 7 - Statement of financial position

Question 15

Step 1 - Sales budget

Answer 15

• This considers how many units can be sold (in revenue terms or units sold)
• Might include sales budgets of several sales regions

Question 16

Step 2 - Production budget

Answer 16

• This considers how many units must be produced to meet the budgeted sales level
• The difference between sales and production budgets is the movement in inventory of finished goods
• Production budget would need to be adjusted for wastage / loss of finished goods

Production budget = Sales budget + Closing inventory - Opening inventory

Question 17

Step 3 - Raw materials budget

Answer 17

This is generally calculated in two parts
- Materials required in production
- Materials purchases

• The difference between these will be movement in inventory of raw materials
• Any losses / wastage during production process will need to be adjusted for
• Purchases budget should also include indirect materials

Question 18

Step 3 - Direct labour budget

Answer 18

• Budget for direct labour costs of production
• If direct labour is variable = Production budget (in units) X Direct labour cost per unit
• Any expected idle time would need to be incorporated into budgeted labour hours
• If direct labour is a fixed cost it can be calculated by estimating the payroll cost

Question 19

Step 3 - Overhead budget

Answer 19

Where a system of absorption costing is used, overheads are allocated and apportioned using budgeted overhead absorption rates

Question 20

Steps 5, 6 and 7 - Master budget

Answer 20

• The master budget can be summarised as a budgeted statement of profit or loss, cash budget and statement of financial position
• If unsatisfactory the functional budgets will need to be revised until a satisfactory planned outcome is achieved

Question 21

A cash budget is an

Answer 21

• Estimate of cash receipts and payments for a future period under existing conditions
• Helps management plan ahead for cash surpluses or shortages
• Shows how long the situation is expected to last which will affect type of action taken

Question 22

Cash budgets are used to

Answer 22

• Assess and integrate operating budgets
• Plan for cash shortages and surpluses
• Compare with actual spending

Question 23

Factors to consider when interpreting a cash budget

Answer 23

• Is the balance at end of period acceptable / matching expectations?
• Does the balance become a deficit at any time in the period?
• Is there sufficient finance (eg overdraft) to cover any cash deficits?
• What are the key causes of cash deficits?
• Can/should discretionary expenditure (eg asset purchases) be made in another period in order to stabilise pattern of cash flows?
• Can/should asset purchases be leased as opposed to being paid for in full in cash?
• is there a plan for dealing with cash surpluses?
• When is the best time to make discretionary expenditure?