Budgeting for Managers

Accounting for Managers

3. BUDGETING

When you have completed this section, you should be able to:

• Explain the benefits of budgeting

• Describe a budgeting process

• Explain the difference fixed and flexible budget

• Prepare a simple flexible budget from a fixed budget

• Compute variances from budget and actual data

• Prepare a cash budget

• Explain the setbacks of traditional budgeting

• Explain the problems of budgetary slack

• Explain the impact of globalization to the budgeting process.

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3.1 INTRODUCTION

Budgeting is a common accounting tool that business use for planning and controlling. .A budget is a plan of future actions. It sets out in management terms and management responsibilities (what management has to achieve) in relations of the requirements of the company's overall objectives.
Subsequently, becomes a document for controlling operations and evaluating performance. A budget may be prepared for any period of time but the budget period should be long enough to provide an attainable goal under normal business conditions. The time period selected should minimize the impact of seasonal and cyclical fluctuations.

Accounting is usually used to express budgetary goals in financial terms. It is used as below:

1. uses historical data on revenues, costs and expenses to predict what will happen in the future

2. periodic reports prepared comparing actual to budget to determine any variances These materials are copyright of WEC. No part of this document is to be reproduced. Copyright and permission clearance to be processed Accounting for Managers

3.2 IMPORTANCE OF BUDGETING

Budgeting is an important process in a management control system of a business. A budgeting process that works well could produce benefits as follows: 1. To aid the planning of actual operations:

© By forcing managers to consider how conditions might change and

what steps should be taken now.

© By encouraging managers to consider problems before they arise.

2. To co-ordinate the activities of the organization:

® By compelling managers to examine relationships between their own operation and those of other departments.

3. To communicate plans to various responsibility centre managers:

© Everyone in the organization should have a clear understanding of the

part they are expected to play in achieving the annual budget.

© By ensuring appropriate individuals are made accountable for implementing the budget.

4. To motivate managers to strive to achieve the budget goals:

® by focusing on participation

® By providing a challenge/target.

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5. To control activities:

© By comparison of actual with budget (attention, directing/management by exception).

6. To evaluate the performance of managers:

© By providing a means of informing managers of how well they are performing in meeting targets they have previously set.

Activity 3.1

Explain any three importance of budget with examples in an organization

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3.3 BUDGET SYSTEM

A well managed business usually has a well planned budget system or process. A budget committee is usually responsible in setting up and maintaining a well established budget system. The Budget Committee is a standing conmiittee responsible for overall policy matters relating to the budget and coordinating the preparation of the budget. A typical flow of budget system could be as follows:

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3.4 TYPES OF BUDGETS

Master budget—a comprehensive profit plan that covers all phases of an

organization's operations. Master budget would contain financial statements that show how the organization financial performance and situation would appear at a specified period of time or for a period of time. Budgeted financial statements include a budgeted income statement, a balance sheet and a budgeted cash flow statement.

3.5 ASSEMBLING THE MASTER BUDGET

The master budget is a comprehensive planning tool for an organization's operations during a specific time period (usually a year). The master budget begins with a sales forecast. Items to consider in deriving a sales forecast include: © Past sales levels and trends ©

General economic conditions ©

Industry trends © Other factors that may affect industry sales ©
Political and legal events © Company pricing policies © Advertising and product promotions ©

Actions of competitors © New products © Market research studies

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While operational budgets vary from firm to firm. Manufacturers' budgets focus heavily on production activities, merchandising firms prepare budgets for purchasing activities, and service firms prepare budgets that show how demand for their services will be met.

MASTER BUDGET

S«IILn� and adm hnisBrative
« peril# budget

Budgetsd ttatcnicot of
'financial
performance

Cash budgtc

statement ot
(inanciai position

Operjiin� twdlgeii

Finincul
I

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3.6 METHODS OF PREPARING BUDGET

Zero based budgeting - Also known as priority based budgeting. It works with the assumption that starts from a zero base as though being launched the first time. It focuses on activities instead of functional departments. All activities in the organization are initially set to zero. In zero based budgeting managers must justify each activity in terms of continued usefulness to the business? Rolling budgets—continuously updated by adding a new time period (e.g., a month) and dropping the period just completed.

Top down budget setting - In this type of budget setting process subordinates have little influence on the target setting process. At times this type

of budget is referred to as non - participatory budget.

Bottom up budget setting - In this type of budget the subordinates are able to influence the figures that are incorporated in the budgets.

Consultative budgeting - In this kind of budgeting process managers would ask subordinates to discuss their ideas of the budget. The preparation of the budget not jointly done by the subordinates and the managers. The manager would prepare the budget on his own but may base on subordinates ideas. These materials are copyright of WEC. No part of this document is to be reproduced. Copyright and permission clearance to be processed Accounting for Managers

3.7 FIXED AND FLEXIBLE BUDGETS

Each component budget in a master budget is a fixed budget. A fixed budget is a projection of budget data at one level of activity. In such budgets, when different activity levels are achieved, the data would not be adjusted for the activity achieved. As such comparison done between actual and budgeted data would be meaningless. This is due as comparison of cost of different levels of activity is useless.

In contrast to static budget, a flexible budget is a series of static budgets at different levels of activity. The flexible budget is more appropriate for comparison purposes as it is could be flexed to the actual activity level before a comparison could be done.

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In the worked example later we could see how a flexible could be derived from a flexible budget and from the flexible budget prepared the variances are computed. Variances are computed by taking the differences between the flexed data and actual data.

When:

i.

Flexed budget cost

> Actual cost it would result in a

favorable variance.

ii. Flexed budget cost

iii. Flexed budget revenue

iv. Flexed budget revenue favorable variance.

< Actual cost it would result in an

unfavorable variance.

> Actual revenue it would result in an

unfavorable variance.

< Actual revenue it would result in a

These materials are copyright of WEC. No part of this document is to be reproduced. Copyright and permission clearance to be processed Units Produced | Budget | Actual | | 10,000 | 12,500 | Direct Costs | | | Direct materials | $ 3,400 | $ 4,330 | Direct labor | $ 5,500 | $ 6,750 | Variable Factory Overhead | | | Utilities | $ 360 | $ 443 | Supplies | $ 120 | $ 162 | Other | $ 300 | $ 370 | Fixed Factory Overhead | | | Office Salaries | $ 2,900 | $ 3,200 | Depreciation | $ 1,000 | $ 1,000 | Other | $ 600 | $ 660 | Total Manufacturing Costs | $ 14,180 | $ 16,915 | | | |
Accounting for Managers

WORKED EXAMPLE

Firm A has provided the following data for the year just ended.

Original
a. Prepare a flexed budget based on the actual units produced.
b. Compute the differences (variances) between the actual cost and flexed cost

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EXAMPLE

Original
Budget

Actual

(a)

Flexed

Budget

(b)
Variance

Units Produced

10,000

12,500

12,500

Direct Costs

Direct materials

Direct labor

$ 3,400
$ 5,500

$ 4,330
$ 6,750

$4,250
$6,875

$80 (U)
$ 125 (F)

Variable Factory
Overhead

Utilities

Supplies
Other

$ 360

$ 120

$ 300

$ 443

$ 162

$ 370

$450

$150

$375

$7 (F)
$12 (U)
$5 (F)

Fixed Factory Overhead

Office Salaries

Depreciation
Other

Total Manufacturing Costs

$ 2,900

$ 1,000
$ 600

$ 14,180

$ 3,200

$ 1,000
$ 660

$ 16,915

$2,900

$1,000
$600

$16,600

$ 300 (U)

60 (U)
$315 (U)

F indicates Favorable variance
U indicates Unfavorable variance

incsc maicriais arc copyngni oi whk. ino pan or mis aociimcni is lo oe reproaucea. l opyngni ana permission cicarancc to dc 40 processed | Budget | Actual | Jnits Produced | 5000 | 6500 | Direct Costs | | | Direct materials | $ 10000 | $ 14330 | Direct labor | $ 5000 | $ 6750 | Variable Factory Overhead | | | Utilities | $ 300 | $ 440 | Supplies | $ 2500 | $ 3000 | Other | $ 500 | $ 670 | "ixed Factory Overhead | | | Office Salaries | $ 10,500 | $ 10,200 | Depreciation | $ 4,000 | $ 4,000 | Other | $ 1600 | $ 1 660 | Total Manufacturing Costs | $ | $ | | | |
Accounting for Managers

Activity 3.2
Firm XYZ has provided the following data for the year just ended.

Original
a. Prepare a flexed budget based on the actual units produced.
b. Compute the differences (variances) between the actual cost and flexed cost

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3.8 CASH BUDGET

The cash budget shows anticipated cash flows for the period. A cash budget is prepared to show the expected cash receipts and cash payments for a certain period of time. The three key sections in cash flow statement are as follows:

© Cash receipts

© Cash payments

© Ending cash balances

Data for preparing this budget are obtained from the other budgets. In order for us to have a good understanding of cash flow it is important that we understand an operating cycle in a business. Below is a simplified diagram of an operating cycle of a retail business

Retail business

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Why does a business need cash?

© Transaction motive

© Meet debts as and when they fall due ©

Precaution motive

© Great uncertainty in business ©

Speculative motive

© Accumulate cash to take advantage of opportunities that emerge

in the future

© Estimated cash inflows & outflows

© showing timing of flows

© balance of cash at any time

© essential for cash management

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3.8.1 PREPARATION CASH BUDGET

In the section of cash receipts all cash inflows in an organization for the specified time period would be recorded as below:

© Cash sales

@ Debtors receipts

© Other receipts (include non-operating revenue, contributions by owners, borrowings, sale of an asset)

While for the section on cash payments all cash outflows in an organization for the specified time period would be recorded. Examples of items that could be found in this section are as follows:

© All cash outflows such as expenses, purchase of assets in cash, payments to suppliers, repayment of borrowings etc

© Ignore "non-cash" items such as depreciation, bad & doubtful

debts provision, discount allowed

These materials are copyright of WEC. No part of this document is to be reproduced. Copyright and permission clearance to be processed Month | Beveragesale | Foodsale | BeveragePurchases | Foodpurchases | Overhead | Laborcost | December | 20,000 | 35,000 | 8,000 | 12,000 | 8,000 | 15,000 | January | 22,000 | 36,000 ] 6,500 | 12,200 | 10,000 | 14,000 | February | 24,000 | 40,000 8,400 | 13,600 | 12,000 | 13,000 | March | 25,000 | 30,000 10,400 | 14,000 | 11,000 12,000 | April | 30,000 | 40,000 8,800 | 14,600 | 9,000 j 15,000 |
Accounting for Managers

WORKED EXAMPLE

From the information given below prepare a cash budget for three months

commencing January 2007 to 31®' March 2007 for a restaurant.

Note:

a) Assume that 80% of total food sales are for cash, with the remanding
20% on credit basis one month. All beverage sales are on cash basis.

b) The payment of all supphers is in the month of purchase while the payment for overheads the time lag is one month.
c) Labor costs is paid in the same month is incurred.
d) The annual interest on the company's investment, $1,600, will be received in March.

e) A new deliver vehicle would be purchased at a cost of $50,000 in
February.

f) The bank balance of the company on January 2004 was $10,000

These materials are copyright of WEC. No part of this document is to be reproduced. Copyright and permission clearance to be processed | January February March | Cash receipts | $ | $ | $ | Food sales | 35800 | 39250 | 32000 | Beverage sales | 22000 | 24000 | 25000 | Interest | - | - | 1600 | Total receipts | 57800 | 63200 | 58600 | | | | | Cash payments | | | | Labor cost | 14000 | 13000 | 12000 | Purchase of food | 12200 | 13600 | 14000 | Purchase of beverage | 6500 | 8400 | 10400 | Purchase of delivery vehicle | - | 50000 | - | Total payments | 32700 | 85000 | 36400 | Net cash flow | 25100 | (21800) | 13300 | Beginning cash balance | 10000 | 35100 | 22200 | Ending cash balance | 35100 | 13300 | 35500 | | | | |
Accounting for Managers

Cash budget for three months ending 31 March 2007.

MONTHS
These materials are copyright of WEC. No part of this document is to be reproduced. Copyright and permission clearance to be processed | March | April | May | June | | $000 | $000 | $000 | $000 | Purchases | 300 | 400 | 500 | 400 | Sales | 800 | 700 | 900 | 900 | Salaries | 100 | 150 | 80 | 120 | Overhead | 160 | 150 | 170 | 170 |
Accounting for Managers

Activity 3.3
The following forecast is available from the present budgets being

prepared Abdee firm.
Other information is as follows: 1. All sales are made on credit basis to customers who pay in the month following sale. 2. All goods are bought on credit from suppliers who allow for payment in the month following purchase. 3. Salaries and wages are paid in the month in which they are earned. 4. Overhead expenses include depreciation amounting to $50,000 each month payments are made in the month following the month in which expenses are incurred 5. A dividend amounting to $24,000 will be paid in
May.
6. A delivery van is to be sold for $18,000 cash in
April.
7. The balance at the bank on 1 April is expected to be
$190,000.
Required:
Construct a monthly cash budget in columnar form for the three months ending June 30th showing the bank balance at each month end

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3.9 BUDGET TOOLS AND ADMINISTRATION

Financial planning models and e-budgeting are two tools that assist in the budgeting process. A financial planning model is a set of mathematical relationships that express the interactions among a firm's operational, financial, and environmental events. Computerized models can be run many times to explore various what-if scenarios with regard to budget variables
(e.g., interest rates, demand, inflation rates, and competitors' actions). With e-budgeting, employees throughout an organization submit and retrieve budget information via the Internet. E-budgeting streamlines the budget process, reducing the time spent on compiling and verifying data submitted from multiple sources on (often) hundreds of spreadsheets.

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3.10 SETBACKS OF TRADITIONAL BUDGETING

Budgeting has been used for decades and the traditional budgeting process has it setbacks. The setbacks are as follows:

© High emphasize on quantitative factors.

© Focuses on individual functional area

© Emphasizes on a fixed time horizon.

® Based on incremental approach as previous year's budget is used as a baseline. 3.11 PRINCIPLES OF EFFECTIVE BUDGETING

© Clearly defined areas of authority and responsibility ©

Realistic goals

© Participation by managers in setting budgets ©

Acceptance by all levels of management ©

Comparison of actual to budget

© Immediate action to be taken where comparisons indicate significant

deviations from budget

© Broken down into periods corresponding to those in the financial

statements.

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3.12 BEHAVIORAL ASPECTS OF BUDGETING

As the budgeting process involves a lot of human factor, the budgets often do

not develop in a smooth manner. Human reactions to the budgeting process

could lead to the following:

© participative budgeting

© budgetary slack

© budget difficulty

Managers who are held accountable for budget performance help develop their own budget estimates. Budget difficulty is another important to be looked into in setting a budget. Optimum performance budget is where the budget provides sufficient challenge and stretch, but is not too difficult. Optimum performance budgets may not be suitable for accurate forecasting. 3.13 BUDGETARY SLACK

Budgetary slack or a process of padding the budget refers to an amount designated in the budget, during the budget setting process that is believed to be unnecessary but included for the sole purpose of having a buffer to insure that the budget is easily achieved.

Two common forms of budgetary slack:

© Overstated cost

© Understated revenue

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Slack is an amount in addition to that which is required, or it is the amount of effort less than one's capability. People often perceive that their performance will look better in their superiors' eyes if they can "beat the budget." This practice of budgetary slack has to be controlled to avoid setbacks in the budgetary controls.

Activity 3.4

Group yourselves in three or four and discuss the following questions:

i. The reasons for budgetary slack to occur in an organization ii. Steps that can be taken in an organization to reduce budgetary slack. These materials are copyright of WEC. No part of this document is to be reproduced. Copyright and permission clearance to be processed Accounting for Managers

3.14 INTERNATIONAL ASPECTS OF BUDGETING

As many businesses are getting globalize firms are exposed with new problems in doing businesses. Firms with international operations face special problems when preparing a budget. The problems are as follows:

o Fluctuations in foreign currency exchange rates.

o High inflation rates in some foreign countries.

o Differences in local economic conditions.

3.15 SUMMARY

Budgeting is an important tool in any businesses. A well established budgeting process must be in existence for the budgeting processes to run smoothly in a business. As businesses goes globalize the budgeting processes needs undergo changes to meet up the challenges.

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TEST QUESTIONS

1. Beginning cash balance plus total receipts
a. equals ending cash balance.
b. must equal total disbursements.
c. equals total available cash.
d. is the excess of available cash over disbursements.

2. The following information was taken from Sloan Ltd's cash budget
For the month of July: Beginning cash balance $90,000

Cash receipts
Cash disbursements

57,000

102,000

If the company has a policy of maintaining a minimum end of the month

cash balance of $75,000, the amount the company would have to borrow is a. $30,000. b. $15,000. c. $45,000. d. $18,000.

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3. A company's past experience indicates that 60% of its credit salesare collected in the month of sale, 30% in the next month, and 5% in the second

month after the sale; the remainder is never collected. Budgeted credit sales

were:

January $ 80,000 February 48,000 March 120,000

The cash inflow in the month of March is expected to be a. $90,400. b. $68,400. c. $72,000. d. $86,400.

4. Generally speaking, which of the following is not one of the primary purposes of a budget? a. Identifying a company's most profitable products. b. Planning. c. Controlling profit and operations. d. Facilitating communication and coordinating activities.

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5 A budget serves as a benchmark against which: a. actual results can be compared. b. allocated results can be compared. c. actual results become inconsequential. d. allocated results become inconsequential.

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