Budgeting and Forecasting PDF

Management Accounting Budgeting and Forecasting Abarowei, John Ebimieowe MSc Accounting  Management Accounting LEARNING OBJECTIVES At the end of this lesson, you should be able to: Define and dierentiate between various types of budgets and forecasting. Analyse the adv...

Management Accounting Budgeting and Forecasting Abarowei, John Ebimieowe MSc Accounting  Management Accounting LEARNING OBJECTIVES At the end of this lesson, you should be able to: Define and dierentiate between various types of budgets and forecasting. Analyse the advantages and disadvantages of each budgeting type. Prepare a cash budget Prepare a flexible budget based on varying levels of production capacity.  Management Accounting Introduction Budgeting and forecasting are essential tools in management accounting that enable businesses to plan, control, and make informed decisions regarding their financial resources. By establishing a framework for future financial performance, these processes support strategic objectives and ensure operational eiciency. While closely related, budgeting and forecasting have distinct purposes and methods that complement each other in the management accounting cycle.  Management Accounting Budgeting Budgeting refers to the process of creating a financial plan for a business over a specific period, typically a year. The primary goal of a budget is to outline expected revenues and expenditures, providing a roadmap for achieving financial and operational objectives. A budget acts as both a planning tool and a control mechanism. It allows businesses to allocate resources eiciently and ensures that operations align with the company’s financial goals.  Management Accounting Types of budgeting Operating Budget Definition: An operating budget outlines the revenue and expenses that an organisation expects during a specific period, typically a fiscal year. It focusses on day-to-day operational activities. Purpose: It serves as a plan for managing the company’s operating income, expenses, and profits. Example: A retail store’s operating budget would estimate the sales revenue, cost of goods sold, and operating expenses such as rent, utilities, and salaries for the upcoming year.  Management Accounting Operating Budget Disadvantages Short-Term Focus: Primarily Advantages focuses on the short term, often Comprehensive Overview: Provides a neglecting long-term planning. detailed plan for day-to-day operations, Rigid: Once set, it may not be covering both revenue and expenses. flexible enough to accommodate Performance Monitoring: Allows for the unforeseen changes in business measurement of actual performance conditions. against budgeted figures, aiding in Assumptions: Relies heavily on accountability. accurate revenue forecasts, which Resource Allocation: Ensures resources can be diicult in volatile markets. are eectively allocated to meet short-term business goals.  Management Accounting Types of budgeting Capital Budget Definition: A capital budget focusses on long-term investments in assets such as property, equipment, or infrastructure. It outlines planned expenditures on capital projects and the expected returns from these investments. Purpose: It helps organisations make informed decisions about major investments and capital expenditures. Example: A manufacturing company planning to purchase new machinery or expand a factory would create a capital budget to estimate the costs and benefits of the investment.  Management Accounting Capital Budget Disadvantages Uncertainty: Future economic Advantages conditions may change, making Long-Term Planning: Focuses on long-term investments riskier than long-term investments, helping anticipated. organisations plan for future growth and Time-consuming: Preparing capital expansion. budgets is time consuming. Investment Prioritisation: Allows for Diicult to Adjust: Once funds are careful evaluation of capital expenditures allocated for capital projects, and potential returns on investment (ROI). changes are often diicult and Prevents Overspending: Helps control costly to make. costs by seing limits on large expenditures.  Management Accounting Types of budgeting Cash Flow Budget A cash flow budget forecasts the movement of cash in and out of the organisation over a specific period. It focuses on the company’s liquidity and ensures that suicient cash is available to meet obligations. Purpose: It helps manage short-term liquidity by tracking cash inflows from sales and cash outflows for expenses. Example: A small business may use a cash flow budget to ensure it has enough cash to pay its monthly rent, salaries, and supplier invoices while waiting for customer payments.  Management Accounting Cash Flow Budget Disadvantages Short-Term Focus: It’s often focused Advantages only on the short term, neglecting the Liquidity Management: Ensures that the organisation’s long-term financial organisation has suicient cash to meet health. its short-term obligations. Volatile Estimates: Cash flow forecasts Cash Flow Forecasting: Allows for can be diicult to predict accurately. proactive financial planning by Limited Insight on Profitability: While it anticipating cash surpluses or deficits. tracks cash, it doesn’t give a complete Immediate Control: Oers immediate picture of overall profitability. insight into cash inflows and outflows.  Management Accounting Types of budgeting Project Budget Definition: A project budget is used for individual projects within an organisation, detailing the expected costs and resources required for the completion of the project. Purpose: It ensures that a specific project stays within its financial constraints and helps allocate resources eectively. Example: A construction company working on a new oice building would create a project budget to estimate costs for materials, labour, and equipment over the project’s timeline.  Management Accounting Project Budget Disadvantages Cost Overruns: Even with a project budget in place, unforeseen costs can Advantages lead to overruns. Specific Focus: Provides a clear financial Limited Scope: Only applicable to plan for individual projects, helping keep specific projects and may not provide a costs under control and within scope. holistic view of the company’s overall Resource Management: Ensures that financial situation. resources are allocated eectively for the Time Constraints: Developing a completion of specific projects. detailed project budget can be Flexibility: It can be adjusted as the project time-consuming, especially for progresses, allowing for mid-course complex projects. corrections.  Management Accounting Types of budgeting Zero Based Budget Definition: Zero-based budgeting (ZBB) requires managers to justify all expenses for each new period, starting from a “zero base.” Every expense must be reviewed and approved, rather than simply adjusting previous budgets. Purpose: It allows organisations to critically assess every expense and allocate resources based on actual needs, promoting cost eiciency. Example: A marketing department using ZBB would have to justify why each advertising expense is necessary, rather than relying on last year’s budget with minor adjustments.  Management Accounting Zero Based Budget Disadvantages Time-Consuming: It requires Advantages significant time and eort, as each line Cost Eiciency: Forces departments to item must be justified from scratch. justify every expense, potentially Complexity: It can become overly eliminating unnecessary or wasteful complex, particularly in larger spending. organisations with multiple Increased Accountability: Managers must departments. evaluate each expense, promoting greater accountability and responsible budgeting. Flexibility: Allows organisations to realign resources based on current needs and priorities.  Management Accounting Types of budgeting Flexible Budget Definition: A flexible budget adjusts based on changes in activity levels or production volumes. Unlike a static budget, which is fixed, a flexible budget allows for fluctuations in revenue and costs. Purpose: It helps organizations respond to changes in operational conditions by aligning budget allocations with actual performance. Example: A hotel might use a flexible budget to adjust staing costs based on occupancy rates. If fewer guests are expected, labor costs will decrease accordingly.  Management Accounting Flexible Budget Disadvantages Complexity: Requires constant Advantages monitoring and adjustment, which can Adaptability: Adjusts for changes in be resource-intensive. business activity levels, making it more Uncertainty: While flexible, it’s still realistic in dynamic business reliant on accurate initial estimates of environments. variable costs and revenues. Beer Control: Allows for more accurate Diicult to Implement: Not all performance evaluations. organizations have the systems in Responsiveness: Helps businesses place to track and update budgets in respond more eectively to fluctuations in real time. market conditions or operational changes.  Management Accounting Types of budgeting Incremental Budget Definition: Incremental budgeting involves making adjustments to the previous year’s budget, typically by increasing or decreasing the figures by a percentage. It assumes that the current operations will continue as they are, with minor adjustments. Purpose: t is a simple and easy-to-implement budgeting method, often used when minimal change is expected.. Example: A government agency may increase its budget for social programs by 5% based on last year’s figures without conducting a detailed analysis of each expense.  Management Accounting Incremental Budget Disadvantages Promotes Ineiciency: Can perpetuate Advantages wasteful spending by assuming that Simplicity: Easy to implement and previous expenditures were necessary understand, as it’s based on adjusting and justified. previous year’s figures by a small Ignores Changing Circumstances: percentage. Assumes that conditions will remain Consistency: Provides continuity and the same, making it less suitable for stability by maintaining established dynamic or fast-changing expenditure levels. environments. Less Time-Consuming: Requires less time and eort compared to other budgeting methods, as changes are often minor.  Management Accounting MID-LESSON QUESTIONS 1. Which type of budget requires starting from zero for each new budget cycle? A Incremental budget B Project budget C Zero-based budget D Cash flow budget  Management Accounting MID-LESSON QUESTIONS 1. Which type of budget requires starting from zero for each new budget cycle? A Incremental budget B Project budget C Zero-based budget D Cash flow budget  Management Accounting MID-LESSON QUESTIONS 1. Which type of budget requires starting from zero for each new budget cycle? C Zero-based budget Explanation: A zero-based budget starts from zero, requiring justification for all expenses in each new period, unlike other budgeting methods.  Management Accounting MID-LESSON QUESTIONS 2. What is an advantage of an operating budget? A It focuses on long-term investments B It helps manage day-to-day business activities C It is only used for capital expenditures D It disregards variable expenses  Management Accounting MID-LESSON QUESTIONS 2. What is an advantage of an operating budget? A It focuses on long-term investments B It helps manage day-to-day business activities C It is only used for capital expenditures D It disregards variable expenses  Management Accounting MID-LESSON QUESTIONS 2. What is an advantage of an operating budget? B It helps manage day-to-day business activities Explanation: An operating budget is designed to cover daily operational costs such as sales, production, and overheads, making it essential for managing short-term operations.  Management Accounting Steps in Budgeting Define Objectives and Goals: Before creating a budget, an organisation must clarify its financial and operational objectives. These could include increasing revenue, reducing costs, or expanding into new markets. Assess Historical Data: Review past financial performance, focusing on revenues, expenses, and cash flow to identify paerns and areas for improvement. Estimate Revenues: Based on historical data, market research, and future projections, estimate the company’s expected income from all sources. Project Expenses: List out expected costs, both fixed (e.g., rent, salaries) and variable (e.g., raw materials, utilities), ensuring every operational aspect is covered.  Management Accounting Steps in Budgeting Prepare a Draft Budget: Combine all the revenue and expense estimates into a preliminary financial document. This draft outlines planned income and costs for each department or function. Review and Approve the Budget: Management reviews the draft, making adjustments based on strategic priorities, available resources, and market conditions. Once finalised, it is approved by the relevant authorities (e.g., finance team, board of directors). Monitor and Control the Budget: After the budget is implemented, continuous monitoring is essential to compare actual performance with the planned budget.  Management Accounting Challenges in Budgeting Accuracy of Data: If the historical data used for projections is incomplete, outdated, or incorrect, it can lead to misleading results. Changing Market Conditions: Market dynamics, such as fluctuating economic conditions, changes in consumer preferences, and technological advancements, can render forecasts obsolete. Budgeting and forecasting are often time-consuming and labor-intensive. Rigid Budgets: Budgets are often static documents created for a specific time period, typically one year. Human Error and Bias: Human involvement in the budgeting and forecasting process can introduce bias or errors.  Management Accounting Challenges in Budgeting Inflexible Organisational Culture: Some organisations have an inflexible culture where budgets are treated as rigid goals that cannot be altered once set. Coordination Across Departments: Budgeting and forecasting require input from various departments, such as sales, marketing, production, and finance. Overemphasis on Short-Term Goals: In some cases, companies may focus too heavily on achieving short-term financial targets, neglecting long-term strategic goals.  Management Accounting Example 1 From the information below, prepare a cash budget for Jaco Ltd. for July, August, and September 2024 in a columnar form. Other Month Sales Purchases Wages Expenses April (actual) 100,000 60,000 25,000 10,000 May (actual) 95,000 55,000 23,000 9,000 June (actual) 90,000 50,000 26,000 11,000 July Budget 110,000 70,000 28,000 10,000 August Budget 105,000 65,000 26,000 12,000 September Budget 100,000 55,000 24,000 11,000  Management Accounting Example 1 You are further informed that: 15% of sales and 20% of purchases are seled in cash. The average collection period for sales on credit is one month. Credit purchases are paid one month after the purchase. Wages are paid 40% in the month they are incurred and the remaining 60% in the following month. The company pays rent of $800 monthly, which is excluded from the listed expenses. Prepare the cash budget accordingly  Management Accounting Workings Cash Budget for 2024. July ($) August ($) September ($) Cash & bank balance 18,000 19,400 19,650 Add: Cash sales (15%) 16,500 15,750 15,000 Credit sales (85%) 76,500 93,500 89,250 111,000 128,650 123,900 Less: Cash outflow Purchases (20%) 14,000 13,000 11,000 Credit purchases (80%) 40,000 56,000 52,000 Wages 26,800 27,200 25,200 Other expenses 10,000 12,000 11,000 Rent 800 800 800 91,600 109,500 100,000 Closing balance 19,400 19,650 23,900  Management Accounting Example 2 Using the following information, prepare a flexible budget for the production of 70% and 90% activity. Production at 50% Capacity 4,000 Units Raw Materials $75 per unit Direct Labour $45 per unit Direct Expenses $10 per unit Factory Expenses $30,000 (Fixed) Administration Expenses (50% Fixed and 50% Variable) $50,000 Prepare the flexible budget accordingly.  Management Accounting Workings Flexible Budget at a Capacity of. Capacity of output units 50% 70% 90% 4,000 5,600 7,200 $ $ $ Raw Materials 300,000 420,000 540,000 Labour 180,000 252,000 324,000 Direct Expenses 40,000 56,000 72,000 Prime cost 520,000 728,000 936,000 Factory expenses 30,000 30,000 30,000 Factory cost 550,000 758,000 966,000 Admin expenses (50%) 25,000 25,000 25,000 Variable 25,000 35,000 45,000 Total Cost 600,000 818,000 1,036,000  Management Accounting Example 3 The following data is available for a manufacturing company for a yearly period: Item Amount ($) Fixed Expenses Wages and Salaries 1,200,000 Rent/Rates and Taxes 720,000 Depreciation 800,000 Sundry Admin Expenses 600,000 Semi-variable Expenses at 50% Capacity Maintenance and Repairs 400,000 Indirect Labour 900,000 Sales Department Salaries, etc. 400,000 Sundry Admin Salaries 300,000 Variable Expenses Materials 24,000,000 Labour 22,000,000 Other Expenses 9,600,000 Total $100,000,000  Management Accounting Example 3 Assume that fixed expenses remain constant at all levels of production. Semi-variable expenses remain constant between 50% and 70% capacity, increasing by 10% between 70% and 85% capacity, and by 20% between 85% and 100% capacity. The sales at various levels of capacity are the following: 50% Capacity: 1,000 60% Capacity: 1,200 75% Capacity: 1,500 85% Capacity: 1,800 100% Capacity: 2,000 Prepare a flexible budget for the year and forecast the profit at 60%, 75%, 85%, and 100% capacity.  Management Accounting Workings  Management Accounting Summary Overview of budgeting types: operating, capital, cash flow, project, zero-based, flexible, and incremental budgets. Each budget type has distinct characteristics, advantages, and disadvantages for specific applications. Cash budgets focus on managing liquidity through cash inflows and outflows. Flexible budgets adjust for varying levels of activity, highlighting the relationship between capacity and profitability. Practical application of preparing budgets enhances understanding of cost behavior and financial planning, aiding business decision-making.  Management Accounting further reading 1. Hilton, R. W., & Pla, D. E. (2018). Managerial Accounting: Creating Value in a Dynamic Business Environment. McGraw-Hill Education. 2. Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2021). Managerial Accounting. McGraw-Hill Education. 3. Drury, C. (2018). Management and Cost Accounting. Cengage Learning. 4. Maher, M. W., & Schmidt, R. (2019). Managerial Accounting. McGraw-Hill Education. 5. Horngren, C. T., Sundem, G. L., & Straon, W. O. (2014). Introduction to Management Accounting. Pearson Education. 6. True Tamplin, BSc, CEPF® (2024). Cash Budgets: Practical Problems and Solutions Management Accounting Thank You