Chapter 17 - Budget

Question 1

Introduction

Planning

Answer 1

Two segments or phases to financial planning:
short-term plan: focuses on the 1 to 2 year time horizon and serves as the basis of the company’s financial budget. It is the starting point for determining how a company intends to attain its profit objectives in the nearer term.

the long term plan (often called a strategic plan), covers a broader span of time, perhaps 3-5 years or more, and places more emphasis on overall company objectives and the proposed methods of obtaining them, than it does on detailed financial figures.

Question 2

Budget Types

Fixed Budget

Answer 2

Fixed Budget
A fixed budget is based primarily on an expected level of activity that will generate an estimated level of revenue and corresponding expenses for a given period of time. Each revenue and expense item is given a definitive monetary value that does not vary across differing levels of activity.

A major purpose of the fixed budget is to compare actual results with planned results. However, this type of a budgeting system provides little flexibility; it does not allow for variations in budgeted categories in relation to differing levels of business activity, such as sales, income, and so on. Fixed budgeting is sometimes criticized as being restrictive because it establishes levels that cannot be modified.

Question 3

Budget Types

Flexible Budget

Answer 3

The flexible budget is usually composed of two elements:

1. an unvarying amount of revenues and/or expenses per accounting period and
2. a variable amount of revenues and/or expenses.

Question 4

Methods of Budgeting

two primary methods of forecasting general business trends.

Answer 4

The first, which is often followed by smaller companies, is based mainly upon the experience and observations of senior executives, often taking into account any literature that is available on existing and developing economic trends.

The second method, which tends to be followed by an increasing number of medium and large sized concerns, includes the use of in-house quantitative techniques often conducted by trained economic analysts.

Question 5

Development of Budgets

Zero-based Budgeting

Answer 5

• This approach requires each manager to justify annually their entire expense budget request in detail, thereby putting the burden of proof on him or her for spending any money at all. The manager must prepare a decision package for every activity to include an analysis of cost, purpose, alternative courses of action, measures of performance, consequences of not performing the activity, as well as its benefits.

Therefore, some of benefits of zero-based budgeting for senior management are as follows:
• Provides top management with detailed information concerning the money needed to accomplish desired ends.
• It spotlights redundancies and duplication of efforts among departments.
• It focuses on dollars needed for programs rather than a percentage increase or decrease from the previous year. This is particularly important in home office departments, where activities are less volume related and where costs usually are not justified on the basis of volume increases.
• It specifies priorities within and among departments and divisions, allowing comparisons across organizational lines.
• It allows an ongoing performance audit to determine whether each activity or operation is performed as budgeted.

Question 6

Development of Budgets

Historically-based Budgeting

Answer 6

Budgets are developed by applying growth factors to base year amounts and projecting other budget line items based upon appropriate interrelationships among the line items.

Question 7

Development of Budgets

Activity-based Budgeting

Answer 7

Connects the performance of a particular activity to the demand that the activity places on a company’s resources.

Expenses are isolated and matched to the activity level that expends resources. In effect, the process relates expenses to the drivers that trigger a specific activity.

Question 8

Development of Budgets

Life Insurance Budgets

Answer 8

the three major elements of a master budget are an income statement, a balance sheet, and a cash flow statement.

Detailed supporting budgets often include sales, cash, investments, and capital expenditures budgets.

Question 9

Development of Budgets

Sales Budget

Answer 9

The forecast of sales is an estimate of what could be sold. Whereas, the budget is what management proposes to sell after considering important data available.

Question 10

Development of Budgets

Expense Budget

Answer 10

An expense budget is the projection of future variable and fixed expense requirements based upon various factors such as economic trends (especially with regard to interest rates, inflation and unemployment levels), historical operating results, and management’s strategic plans over the budget period.

Question 11

Development of Budgets

Allowable Expenses

Answer 11

deals with the identification of expense margins built into the pricing of various insurance products

Question 12

Development of Budgets

Staff-based Budgeting

Answer 12

Another method for developing expense budgets is based upon projected staffing levels that are related to specific work volumes. Historical relationships can be developed between staff counts and expense levels in total or on a department basis. The ratios of staff to expense would then be applied to projected future staffing levels. Inflation should also be factored into this process.

Question 13

Development of Budgets

Departmental Budgets

Answer 13

Detailed expense budgets are often prepared by, and for, departments within the home and regional office. These expense budgets include staff counts, salaries, benefits and related expenses, as well as other so-called controllable expenses, such as travel, automobile, furniture and equipment, rent, telephone, temporary manpower, postage, and printing.

Question 14

Development of Budgets

Cash Budget

Answer 14

For this reason, the cash budget is an important tool for management to use to forecast cash deficiencies and surpluses over a specific period of time, and to arrange to borrow, repay or invest funds as necessary and as efficiently as possible.

The cash budget assists the treasurer and investment officer in determining and maintaining an acceptable minimum level of cash on hand, minimize borrowing costs and maximize short-term investment income, while matching assets and liability risks properly.

the cash budget does not follow the accrual method of accounting.

“cash conversion” process: This process utilizes the trial balances that the company maintains to meet statutory reporting requirements, along with the GAAP financial statements that were prepared for the same period.

Question 15

Development of Budgets

Capital Expenditures Budget

Answer 15

Capital budgeting provides a process for evaluating, selecting, and acquiring longterm assets and investing in long term projects.

New buildings, computer systems, product development and the acquisition of businesses all fall into the category of capital investments.

Capital investment requests or ideas fall into two general categories -
1. mandatory: Over time equipment and other property wear out or become technologically obsolete (as with computers) and need to be replaced.

2. discretionary .Discretionary investments are not generally required for the continuance of business but for enhancing the value of the firm. These investments can be classified as
   • new revenue enhancing projects, such as developing a new product or buying an insurance company,
   • cost reduction investments, such as a new automated bill processing system, and
   • expenditures required to address safety and/or regulatory concerns, which in some cases may be mandatory

Question 16

Non-Discounting Models

Answer 16

The payback period model helps management determine how long it will take to recover their initial investment. The basic equation, used when annual cash flows are expected to be even, is as follows:

Payback period = Original Investment / Annual Cash Flow

Question 17

Discounting Models

Answer 17

This discount rate generally reflects the minimum acceptable rate of return that can be earned on a project. This rate is also commonly referred to as the hurdle rate or the firm’s cost of capital.

The cost of capital is essentially the weighted average cost of all sources of debt and equity capital available to the firm.

NPV: The second discounting method is net present value, which finds the difference between the present value of all future cash inflows and the required cash outflows.

IRR: Lastly, the internal rate of return (IRR) method seeks to find the discount rate, or interest rate, that will make the net present value of a project equal to zero.

NPV and IRR analysis of an independent project will encourage the same decision, whether to accept or reject the proposal, the two methods can lead to different rankings of mutually exclusive projects. In such cases, decisions should be based on the NPV rankings. Although NPV analysis has its weaknesses, this model calculates the additional absolute value that is added to the firm from a project

Question 18

Budget as a Management Tool

Answer 18

There are essentially three steps in the executive control of operations against an adopted budget:

1. reporting results,
2. analyzing and interpreting the results. (related to budget control procedures)
3. taking action if/when warranted. (related to management)

Question 19

Budget as a Management Tool

Follow-up Variance Control

Answer 19

these variations fall into two categories:

1. those that are revenue related e.g., 1st year and renewal premium, net investment income, changes in reserve, and
2. those that are expense related e.g., policy benefits, taxes, increase in policy reserves, and commissions to agents.

Question 20

Budget as a Management Tool

Variations Measure Validity of Planning

Answer 20

Deviations from the budget can be a useful tool for management, for they are apt to indicate one of three major problems:
• A faulty budget making process has been created.
• Management has failed in its commitment to work the budget.
• Economic conditions have invalidated certain budgetary premises, creating a variance between actual and budget.

Question 21

Types of Budget Reports

Answer 21

In designing such reports, there are three principal considerations: content, destination, and timing.

Question 22

Forecasting

Answer 22

Forecasting can be handled in two ways.
1. can be treated as a continuous process in which information is exchanged on an ongoing basis.

2. can be treated as a formal periodic step in the yearly planning cycle.

Question 23

Practical Considerations in Budgeting

Answer 23

• Period Covered by Budget
• Realism: Every budget must represent realistically obtainable goals and objectives
• Flexibility
• Information or Uncertainty

Question 24

Development of Budgets

Budgeting Philosophy

Answer 24

• Top-down. Companies differ dramatically in the form of participation and influence they afford their operating managers in the budget process. The top-down method avoids “general participation” budgeting; whereby senior management sets the budget with limited involvement by middle and lower management.

The primary advantages of the top-down approach are the speed with which the budget can be prepared and the guaranteed reflection of senior management’s goals. The negatives of the approach include a lack of commitment by non-participating managers to accept the budget as their own, the limited incentive for line managers to operate within its guidelines, and the possible absence of pertinent operating level information.

Bottom-up. Often operating managers are permitted some participation in budget setting.

However, there are several disadvantages of this approach. First, since each field office is developing its own goals based upon its own unique set of assumptions, inconsistencies and contradictions may arise.