notes iii Internal W9 Budgeting

Question 1

Financial statements

Answer 1

Summary of historical performance and the recent financial position

Question 2

Strategic planning

Answer 2

– Focus on planning for the future
– Conducted by senior management, focussing on the broad strategic direction over the long-term (3 to 5 years), considers key issues such as expansion, restructuring, new product or service development, new production or operational techniques

Question 3

Budgets

Answer 3

– Operationalise the strategic planning by 1. quantifying financial goals and expectations over the short-term (12 months)

– Non-financial goals (such as employee or customer satisfaction) can be quantified using the balanced scorecard

– 2. Part of planning and control within organisations

• Budgets 3. assist management’s control over operations by providing a benchmark with which to compare actual results

4. Done at regular intervals during the period to monitor progress
   – corrective action necessary
   – the budget can be adjusted in line with new information

Question 4

Budgeting cycle

Answer 4

• Planning
• Assess past performance & expected operating conditions
• Establish operational objectives
• Prepare budgets
• Implementation
• Allocate resources
• Evaluation
• Ongoing monitoring of actual performance against budget
• Make adjustments necessary
• Review
• Operating strategies and budget processes

Question 5

Characteristics of effective planning: Duration

Answer 5

Duration

rather than remain static, budgets may be prepared on a

rolling basis to ensure a

constant 12-month budget is in place

Question 6

Characteristics of effective planning: Timing

Answer 6

Timing

Time frame should be manageable and relevant (the longer the projection the less reliable forecasting becomes)

Question 7

Characteristics of effective planning: Adjustments

Answer 7

Adjustments

capable of adjustment as new information comes to light during the period

Question 8

Characteristics of effective planning: Approaches

Answer 8

Which Approach?
• Authoritarian (where budget imposed on business units from above)
• Participative (where budget is formulated through negotiation and feedback between senior management, business unit managers and employees)
-Participatory Approach Is More Likely To Result In:
a budget that better represents the economic reality of a particular business unit, and
employees and managers being more accepting of budget targets

Question 9

Characteristics of effective planning: Additions

Answer 9

Additions
– Setting Realistic And Achievable Targets(but still challenging)
– Ensuring responsibilities and accountabilities match control

Question 10

Planning: Data: Conservatism

Answer 10

rev & profit: choose lower

expenses: choose higer

Question 11

Characteristics of effective planning:

Answer 11

timing

Duration

Adjustments

Which Approach?

Additions
– Setting Realistic And Achievable Targets(but still challenging)
– Ensuring responsibilities and accountabilities match control

Question 12

Planning: Data: where do they come from?

Answer 12

Incremental budgeting

• Zero-based approach –

• Some figures are already known
(orders, contracts, loans)

• Some figures have cost drivers
(sales volume drives variable costs)

External factors
(economic, social and market factors)

Question 13

Planning: Data: Incremental budgeting

Answer 13

Incremental budgeting

uses previous year’s results as a starting point and justify increases or decreases for upcoming year

Question 14

Planning: Data: Zero-based approach

Answer 14

Zero-based approach –

re-sets all budgets to zero and then each figure is justified on a cost-benefit basis

Question 15

Planning benefits

Answer 15

-Manage problems in advance
(resource constraints, cash shortages, financing needs) or identify opportunities (excess capacity, excess cash)

-Strategy testing and sensitivity analysis
consider impact of results

-Promotes coordination and communication within organisation

Question 16

Planning: Control

Answer 16

-Once the budget is implemented it can facilitate control by:

– Providing defined financial objectives and enabling responsibility to be assigned to all levels of management
– Motivating employees and managers to achieve targets
incentive schemes
– Enabling ongoing monitoring of performance throughout period
– Providing a yard stick for evaluation of performance at the end of the period (comparing actual results with budgeted)
enhances analysis and may be used as a basis for rewarding employees and managers

Question 17

Planning: Unintended consequences

Budgetary slack

Answer 17

Unintended consequences

Budgetary slack
• Budget may have built-in slack to ensure the target is achieved
Those responsible for implementing budget may influence budget formulation process to increase likelihood of achieving target
(unintended consequence of participative approach)

Question 18

Planning: Unintended consequences

Disincentive beyond the target

Answer 18

Disincentive beyond the target
• Once target is met, any incentive to keep performing?
Difficult targets create disincentives
• If target is too difficult, no incentive to try
Demotivating

Question 19

Planning: Unintended consequences

Discretionary / unnecessary spending

Answer 19

Discretionary / unnecessary spending
• Unnecessary expenditure to ensure future budgets are not cut
Reluctance to incur necessary or value-adding expenditure
• Necessary expenditure avoided to ensure target is achieved

Question 20

Planning: Unintended consequences

3

Answer 20

Budgetary slack

Disincentive beyond the target

Discretionary / unnecessary spending

Question 21

Master budget

Def

Model

Answer 21

an aggregated set of interrelated budgets covering the various functional areas and the budgeted financial statements

*Sales -> *Purchases budget -> *Operating expenses budget -> Budgeted income statement -> (Capital expenditure budget ->) Cash budget -> Budgeted balance sheet

• = operating budget
  the rest = financial budget

Question 22

Master budget: Operating budgets –

Answer 22

Operating budgets –
specific revenue and operating expenses
e.g. selling, marketing, administrative

Question 23

Master budget:

Financial budgets –

Answer 23

Financial budgets –

cash budgets, capital expenditure budget, budgeted profit & loss and budgeted balance sheet

Question 24

Master budget: 1 Sales budget

definition

formula

Answer 24

Determined by aggregating for every product / service line:

Expected volume of sales x Intended selling price

Expected sales volume (and mix) determined by:
historical trend data, advertising policies, market research, economic trends and consumer preferences (impacts disposable income and demand), competitor’s behaviour, the entity’s own capacity

Intended selling price determined by:
Costs, desired profit margins, competition, pricing policy

Question 25

Master budget: 1 Sales budget:

Expected sales volume (and mix) determined by:

Answer 25

Expected sales volume (and mix) determined by:
historical trend data, advertising policies, market research, economic trends and consumer preferences (impacts disposable income and demand), competitor’s behaviour, the entity’s own capacity

Question 26

Master budget: 1 Sales budget:

Intended selling price determined by:

Answer 26

Costs, desired profit margins, competition, pricing policy

Question 27

Master budget: 2 Purchase Budget

Function

total inventory required & required purchases formulas

Answer 27

Determines volume of units required to be purchased to meet expected sales

Determining optimum inventory level
problems with too much (storage, insurance cost, tired working capital, theift, obsolete) or too little (x meet demand & choice)

Budget cost of sales + desired inventory – inventory at start = required purchases
Budget cost of sales + desired inventory = total inventory required

Question 28

Master budget: 3 Operating Expense Budget

Answer 28

All expenses between gross profit and EBIT
Individual budgets for each cost centre (sales & marketing, administration)

Variable costs
determined by budgeted sales volume

Fixed costs
known or estimated costs

Question 29

Master budget: 4 Budgeted income/ profit or loss statement

Answer 29

• Combines the individual operating budgets (sales, purchases and operating expense budgets)
• Determines budgeted EBIT performance for the period
• Can be used to compare against actual results at period end

Question 30

Capital expenditure budget 5

Answer 30

Capital expenditure budget
• Planned expenditure relating to non-current assets (PPE)
major refurbishments
Acquisitions (does current PPE have sufficient productive capacity to meet sales budget), expansion plans

Question 31

Cash budget 6

2 components

Answer 31

Cash inflows –
expected receipts from:
– customers(using details from the sales budget)
– interest and dividends to be received
– proceeds from planned asset disposal sand share issues

Cash outflows –
expected payments:
– to suppliers and employees (using details from purchases and expense budgets)
– relating to PPE(from the capital expenditure budget)
– proposed dividends

Question 32

Cash budget 6

prepared on what basis/ frequency

Answer 32

cash budget should be prepared on a month-by-month basis rather than on an aggregated basis for the period to identify any cash shortages or excesses during the period rather than simply at the end:

Question 33

Cash budget 6

relationship to financing CF

Answer 33

The expected cash position resulting from operating and investing activities determines the funding requirements or repayment capabilities
i.e. financing activities

• Complete the budgeted income statement after determining the interest expense and tax expense
• Complete the cash budget (including the estimated final cash position) after determining the financing cash flows i.e. inflows or outflows related to borrowings, outflows relating to interest and tax payments

Question 34

Budgeted balance sheet 7

Answer 34

• Combines actual balance sheet data from the previous period and the expected results from the budgeted income statement, the capital expenditure budget and the cash budget
• Determines the projected financial position at the end of the budget period

Question 35

Cash budget 6

Analysing

Answer 35

Planning & control: Analysing the cash budget
• Once the cash budget is completed management can identify times of projected cash shortages (e.g. overdraft) or excesses (able to invest it in a term deposit or interest bearing debt) during the budget period

Excess -
Consider strategies to take advantage of excess cash situations such as investing in short-term deposits or repaying interest-bearing debt

Shortage-
Cash shortages are identified management can consider strategies to increase projected inflows or decrease projected outflows
– Arrange external finance or seek additional capital injections (issue more shares)
– Liquidate Investments/dispose of non-currentassets/defer capital expenditure
– Take Advantage Of/seek to extend credit terms

Question 36

Cash budget 6

Analysing

e.g. deficit solutions

Answer 36

• Arrange an overdraft (the most expensive form of credit)
  An overdraft occurs when money is withdrawn from a bank account and the available balance goes below zero. … If there is a prior agreement with the account provider for an overdraft, and the amount overdrawn is within the authorized overdraft limit
  But significant cost of interest

Cancel / delay the purchase

Finance purchase with (some) debt
Don’t need to borrow full amount, only need enough to reverse overdraft
e.g. 50% of price

Liquidate the $25,000 term deposit
forego all or part (if interest is paid on pro rata basis) of the $500 interest revenue

Question 37

Variances

F or U

Answer 37

• Variances are identified as either favourable (F) or unfavourable (U)
– F when actual revenue/receipts/assets>budget
– U when actual expenses/payments/liabilities>budget

Question 38

Variance reports

Answer 38

Done at the end of the period to determine variances between actual results and budget forecasts

Question 39

Variance reports Evaluation

Answer 39

Once variances identified, management apply a materiality threshold (based on its own established guidelines) to determine which variances are significant
• Management then seeks explanations / investigates causes (whether favourable or unfavourable)
Volume Related e.g. extra sales /efficiency related
External Factors Beyond Control Of Entity
Maybe Due To Forecasting Errors e.g. too optimistic
Management then considers appropriate response / corrective action
e.g. rewards, pemalty