7.1 Preparing budgets Flashcards
A budget is a
- 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
Purposes of budgeting
- Planning
- Control and evaluation
- Coordination
- Communication
- Motivation
- Authorisation
Purpose of budgeting - Planning
- 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
Purpose of budgeting - Control and evaluation
- 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
Purpose of budgeting - Coordination
- 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
Purpose of budgeting - Communication
- 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
Purpose of budgeting - Motivation
- It can be a useful device for influencing managerial behaviour and motivating managers to perform in line with the org objectives
Purpose of budgeting - Authorisation
- 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
Advantages of budgeting
- 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
Disadvantages of budgeting
- 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
Functional budgets
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)
A master budget is a
- 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
Key factor / Principal budget factor (aka limiting budget factor)
- 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
Budget preparation stages:
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
Step 1 - Sales budget
- This considers how many units can be sold (in revenue terms or units sold)
- Might include sales budgets of several sales regions
Step 2 - Production budget
- 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
Step 3 - Raw materials budget
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
Step 3 - Direct labour budget
- 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
Step 3 - Overhead budget
Where a system of absorption costing is used, overheads are allocated and apportioned using budgeted overhead absorption rates
Steps 5, 6 and 7 - Master budget
- 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
A cash budget is an
- 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
Cash budgets are used to
- Assess and integrate operating budgets
- Plan for cash shortages and surpluses
- Compare with actual spending
Factors to consider when interpreting a cash budget
- 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?
