Budgeting and Corporate Objectives

Learning Objectives

• Define a budget
• Explain how budgets, corporate objectives, and long-term plans are related
• Set out the main components of the budget-setting process and explain how the various budgets interlink
• Identify the main uses of budgeting
• Construct various budgets, including the cash budget, from relevant data
• Use a budget as a means of exercising control over the business
• Explain and apply flexible budgeting
• Calculate a series of variances between budget and actual to help control activity
• Identify the limitations and behavioral implications of the traditional approach to control through budgets and standards
• Assess the contribution and importance of budgeting in practice

Budgets, Long-Term Plans, and Corporate Objectives

• Corporate objectives identify the broader goals of the business
• A long-term plan defines the general direction of the business over a period, such as five years. It covers specifics like the market(s) the business aims to serve, production/service methods, profit levels, financial/financing requirements, and personnel.
• A budget is a financial plan for the future. It is expressed in financial terms and converts the long-term plan into an actionable blueprint for the future.

The Planning Process

• Identify business objectives
• Consider options
• Evaluate options and make a selection
• Prepare long-term plans (long-term budgets)
• Prepare budgets (short-term)

Time Horizons of Plans and Budgets

• Long-term plans are typically 5 years and budgets are typically set for 12 months.
• Plans aren't always fixed. Management may have flexibility.
• The length of a plan depends on the industry, for example, 5 years in an IT business might be too long due to rapid change.
• Budgets can also be 'rolling' (monthly).

Budgets and Forecasts

• Budgets and forecasts are different.
• A budget is a future plan, primarily in financial terms.
• Forecasts predict the future state of the environment.
• Forecasts are helpful for planners/budget setters.

The Interrelationship of Various Budgets

• A business typically has multiple budgets, each linked to a specific business aspect.
• Ideally, each manager has a separate budget.
• A diagram showing the interrelationship between various budgets (such as cash, sales, overhead, capital expenditure, direct labor, raw materials purchases, finished inventories, and raw materials inventories) is presented.

The Budget Setting Process

• Establish who is responsible for budget-setting.
• Communicate budget guidelines to relevant managers.
• Identify the key or limiting factor.
• Prepare the budget for the area of the limiting factor.
• Prepare draft budgets for all other areas.
• Review and coordinate the budgets.
• Prepare the master budgets.
• Monitor performance relative to the budgets.

The Budget Setting Process (cont'd)

• Budget committee: A group of managers overseeing the budget-setting process.
• Budget officer: An individual (often an accountant) responsible for the committee's tasks.
• Top-down approach: Senior management sets budget targets.
• Bottom-up approach: Lower-level staff (e.g., sales representatives) input into the budget.

The Uses of Budgets

• Promote forward thinking and identify potential short-term problems.
• Help coordinate different business sections.
• Motivate managers to achieve better performance.
• Provide a basis for a control system.
• Provide a system of authorization for spending up to a limit.

Preparing the Cash Budget

• The cash budget is crucial; all business aspects are, ultimately, reflected in cash.
• The cash budget provides a complete view of the business more than any other single budget.

Preparing the Cash Budget (cont'd)

• Most cash budgets are broken down into monthly sub-periods.
• They are presented in a columnar/table format, with one column per month.
• Cash receipts and payments are listed, and a total for each month is shown.
• Monthly cash surpluses or deficits are identified.
• A running cash balance is recorded.

Preparing Other Budgets

• Other budgets use the same format as the cash budget.
• Examples include debtors, creditors, and inventories budgets.

Using Budgets for Control

• Control involves making events align with the plan.
• Budgets are the plan's foundation for controlling the business.
• The planning and control process typically follows a sequence shown in a diagram.

The Planning and Control Process (cont'd)

• Identify objectives
• Consider options
• Evaluate options and make a selection
• Prepare budgets (short-term)
• Prepare long-term plans (long-term budgets)
• Perform and collect information on actual performance
• Identify and analyze differences between plans and actuals (variations)
• Respond to variances and exercise control
• Revise plans (and budgets) if necessary

Using Budgets for Control (cont'd)

• The primary budget target is profit. Actual results are compared to budgeted results.
• Actual costs incurred are compared to the budgeted costs for the level of production achieved.

Using Budgets for Control (cont'd)

• Flexed Budget—a revised budget for actual activity levels.
• Fixed and variable costs are distinguished—flexed budgets reflect expected costs at realized activity levels.
• Compare flexed budget profit with actual. This is a more accurate comparison.
• Sales volume variance—the difference between the original budget and the flexed budget's profit figure.

Variances

• Key Variances—Sales volume (quantity) variance, Sales price variance, Materials variances (Total direct materials variance, Direct materials usage variance, Direct materials price variance), Labour variances (Total direct labor variance, Direct labor efficiency variance, Direct labor rate variance), Fixed overhead spending (expenditure) variance.

Standard Quantities and Costs

• Standards are planned quantities/costs used as budgetary building blocks.
• Standards are benchmarks to measure actual performance.
• Variances are calculated from standards, and these variations are based on actual performance.
• Standards require regular review and adaptation if needed.
• Budgets are extended beyond control.

Investigating Variances

• Variance investigations can be expensive and time-consuming.
• They're only useful when management can enact plans to achieve future goals.
• Significant adverse variances deserve thorough investigation due to potential financial impact.
• Significant favorable variances represent issues not anticipated, potentially resulting in under-achievement.
• Insignificant variances should also be monitored to potentially identify unexpected trends.

Necessary Conditions for Budgetary Control

• Senior management's commitment to the process.
• Defined areas of management responsibility.
• Reasonable budget goals.
• Data collection, analysis, and distribution are essential for performance assessment.
• Specific reporting (not general).
• Regular reporting cycles.
• Timely variance reports to managers.
• Action taken to correct deviations.

Limitations of Control Through Variances and Standards

• Not all costs are directly tied to production.
• Standards can quickly become outdated due to technology or price changes.
• Factors beyond management control influence the budget.
• Defining clear management responsibilities can prove difficult in practice.

Behavioral Aspects of Budgetary Control

• Budgets generally improve performance.
• Challenging (but attainable) targets are more motivating than easy ones.
• Unrealistic targets negatively affect performance.
• Allowing managers to set their targets can boost motivation, commitment, and performance.

Criticisms of Budgetary Control

• Budgets can be time-consuming and expensive.
• They aren't always strategically driven.
• Different budgets are often needed for multiple managerial functions.
• Budgets can stifle entrepreneurial spirit.
• Outdated budgets might miss modern business needs, hindering adaptability.
• Potential for misinterpretations, leading to undesirable actions or behaviors.
• Projects can be stifled because resources are allocated.
• Internal focus is a possible implication.
• Centralization might reduce involvement and accountability in budgeting.

Review

• Any budgetary control system must ensure that the business environment is understood.
• The business should develop a suitable culture.
• The budget's link to the strategic plan is crucial.
• A culture that promotes value-adding is essential.