Week 8 Lectures: Budgeting PDF

Faculty of Management Bournemouth University Business School Department of Accounting, Finance & Economics Week 8 Lectures: Budgeting Dr Akanga www.bournemouth.ac.uk  Learning Outcomes By the end of this unit  Explain the purpose and nature of a...

Faculty of Management Bournemouth University Business School Department of Accounting, Finance & Economics Week 8 Lectures: Budgeting Dr Akanga www.bournemouth.ac.uk  Learning Outcomes By the end of this unit  Explain the purpose and nature of a budgeting system  Explain how budgeting is used for planning and control  Understand the different types of budgets  Explain the benefits of budget  Prepare different budgets and explain how they lead to the master budget www.bournemouth.ac.uk  Definition and Role of Budgets A budget is a quantitative expression of a proposed plan of action by management for a future time period It can cover both financial and non-financial aspects (such as planned revenue, expenses, assets, liabilities and cash-flows) of these plans and acts as blueprint for the company to follow in the forthcoming period. Serves as an aid to planning and controlling an organisation’s activities in order to achieve certain objectives. www.bournemouth.ac.uk  Budgeting process The first step therefore must be determining the objectives to be achieved, and this should be followed by a process where all departments affected are brought together so that they can all work together towards a common goal. It is also very useful to look back at the previous year’s performance. It can serve as a good yardstick for preparing the budget for the coming year. www.bournemouth.ac.uk  Budgeting process www.bournemouth.ac.uk  Effects of Budgetary Control Budgets are tools that by themselves are neither good nor bad. How managers control budgets is the key to their value. When administered wisely, budgets can serve the following useful purposes: 1. Compel strategic planning including the implementation of plans 2. Provide performance criteria 3. Promote communication and coordination within the organisation; and 4. Affect motivating and wider organisational processes. www.bournemouth.ac.uk  Effects of Budgetary Control In order to use budgets as control mechanisms, it is necessary that actual results are subsequently compared with the budgets and any necessary corrective action taken. Budgeting is most useful when done as an integral part of an organisation’s strategic analysis. Strategy can be viewed as describing how an organisation matches its own capabilities with the opportunities in the marketplace to accomplish its overall objectives. www.bournemouth.ac.uk  Strategic Analysis Long-run Long-run Planning Budgets Strategic Analysis Short-run Short-run Planning Budgets e that the arrows in the diagram are pointing in two directi ecause strategy, plans and budgets are interrelated and affe ne another. Budgets provide feedback to managers about th ikely effects of their strategic plans. Managers then use thi feedback to revise their strategic plans. www.bournemouth.ac.uk  Preparation of a budget Preparation of a budget requires a number steps: a) determining objectives b) identifying resources required c) estimating the cost of the requirements d) reviewing and coordinating objectives and resources, and assessing the financial consequences e) finally approving the budget. www.bournemouth.ac.uk  Preparation of a budget Given below are the main different types of budgets prepared by organisations Sales, Production, Materials, Labour, Overhead, etc www.bournemouth.ac.uk  The Sales Budget The sales budget shows projected sale quantities and prices. Provides predictions of total revenue from which cash reception from customers can be estimated. Provides data for constructing other budgets (production cost, selling and distribution, etc) www.bournemouth.ac.uk  Example 1 You are required using the information given below, to prepare budgets for the month of May for: 1. Sales in quantity and value, including total value; 2. Production quantities. www.bournemouth.ac.uk  Example 1: Sales or Revenue Budget Product Quantity Price (units) each (£) Sales A 1 000 100 B 2 000 120 C Product 1 500 Product 140 Product A B C Opening 1 000 1 500 500 stock 1 100 1 650 550 Closingwww.bournemouth.ac.uk  Solution 1: Sales or Revenue Budget Produc Product Produc Total t B t A C Sales 1000 2000 1500 quantities * * * Selling £100 £ 120 £ 140 prices £100.0 £ £ £550. Sales 00 240.00 210.00 000 value www.bournemouth.ac.uk 0 0  An Important Remark closing Sales qty. + =Qty. needed-Ope. stock stock www.bournemouth.ac.uk  Solution 2: Production Quantities Budget Product Product Product A B C Sales 1 000 2 000 1 500 quantities 1 100 1 650 550 + Closing stock 2 100 3 650 2 050 (1 000) (1 500) (500) = Quantity needed 1 100 2 150 1 550 - Opening www.bournemouth.ac.uk  Example 2 TT Company is a distributor of lawnmowers. The following information is available about the company’s operations: 1. The cash balance on 1 June will be £80 000 and the company must maintain a minimum cash balance of £40 000. An open line of credit is available from the company’s bank to bolster the cash position as needed. 2. Actual sales for April and May and expected sales for June are as follows: April(£) May (£) June (£) Cash Sales 130 000 140 000 166 000 Sales on account 800 000 1 050 1 200 000 000 www.bournemouth.ac.uk  Example 2 Sales on account are collected over a three-month period in the following ratio: 30% collected in the month of sale, 50% collected in the month following sale, and 17% collected in the second month following sale. The remaining 3% is uncollectible. 3. Purchases of stock will total £560 000 for June and 40% of a month’s stock purchases are paid during the month of purchase. The accounts payable remaining from May’s stock purchases total £322 000, all of which will be paid in June. 4. Selling and administrative expenses are budgeted at £840 000 for June. Of this amount, £100 000 is for Depreciation. In addition, a new web server for the Marketing Department costing £152 000 will be purchased for cash during June, and dividends totalling £18 000 will be paid during the month. www.bournemouth.ac.uk  Required [a] Prepare a schedule of expected cash collections for June. [b] Prepare a schedule of expected cash disbursements during June to suppliers for materials for stock purchases. www.bournemouth.ac.uk  Solution to Example 2 a). Schedule of cash collections (Sales) as far as June is concerned : June Cash Sales in June £166 000 Collections on account: April sales = £136 000 May sales = £525 000 June sales = £360 000 Total cash collections for June £1 187 000 www.bournemouth.ac.uk  Solution to Example 2 b. Schedule of cash payments to suppliers as far as June is concerned : June May purchases (creditors) £322 000 June purchases: £224 000 Total cash payments in June £546 000 www.bournemouth.ac.uk  Sales Budget Units x Selling price = Total Sales Example 1. Our Parents enterprises specialises in the production of winter coats. Budgeted sales (units) for the months of April, May, June and for the quarter were 20.000, 50.000, 30.000, 100.000 respectively. Each coat was sold for £16. Prepare a sales budget for the three months and the quarterly sales budget. www.bournemouth.ac.uk  Solution to Example 1 www.bournemouth.ac.uk  Production budget Units Sales X Add : Closing stock X Less : Opening stock ( X) Production required X www.bournemouth.ac.uk  Direct materials usage budget Direct material cost: i) Quantity of Materials/unit X production required = Total Quantity of materials ii) Total Quantity of materials X price per unit = Direct material cost www.bournemouth.ac.uk  Direct Labour Cost budget Direct labour cost: i) Production units X direct labour hours required = Total direct labour hours required ii) Total direct labour hours X Direct labour rate/hour = Direct labour cost www.bournemouth.ac.uk  Variable Production Overhead budget Direct Variable Overhead cost: (Assuming based on direct labour hours) i) Production units X direct labour hours required = Total direct labour hours required ii) Total direct labour hours X Variable Overhead rate rate/hour = Direct variable overhead cost www.bournemouth.ac.uk  Cash budget A Cash Budget states all the cash inflows and outflows for a certain period of time. Sometimes the cash budget is also called “Statement of budgeted cash receipts and disbursements”. A cash budget is not the same as an income statement. Main Differences with the Income Statement:  Depreciation is not included  Loans are included  Dividends are included www.bournemouth.ac.uk  Main elements of a Cash Budget The main elements of a cash budget are: Cash collections from customers (IN) Cash disbursements for purchases (OUT) Cash disbursements for operating expenses (OUT) Capital Expenditures (OUT) Loans (IN) Loan repayments (OUT) As you can see everything is either IN or OUT. www.bournemouth.ac.uk  Types of Budgets Flexible budgets Zero based budget Activity Based Budget (ABB) Kaizen Budget Continuous budget www.bournemouth.ac.uk  Flexible Budgets Key assumptions of a flexible budget are: Total variable costs change in direct proportion to changes in activity. Total fixed costs remain unchanged within the relevant range. A flexible budget is the difference between the actual revenues and the cost drivers If operating income increases relative to the budgeted amount, we refer to it as a favourable variance. But if the operating income decreases relative to the budgeted amount, we refer to it as unfavourable variance. www.bournemouth.ac.uk  How to develop a flexible budget Developing a flexible budget requires a five step approach  Determine the budgeted selling price per unit, the budgeted variable cost per unit and the budgeted fixed cost  Determine the actual quantity sold (revenue driver)  Determine the flexible budget sales based on the budgeted sales price and the actual quantity sold  Determine the actual quantity of cost driver. This should be the number of units produced and sold  Determine the flexible budget for costs based on the budgeted unit variable costs and fixed costs and the actual quantity www.bournemouth.ac.uk  Flexible Budgets Benefits: Show revenues and expenses that should have occurred at the actual level of activity. May be prepared for any activity level in the relevant range. Reveal variances due to good cost control or lack of cost control. Improve performance evaluation. www.bournemouth.ac.uk  Zero Budgets It is also known as ‘priority-based budgeting’ It requires that all activities are justified and prioritised (cost-benefit analysis) before decisions are taken relating to the amount of resources allocated to each activity. It focuses on programmes (extending childcare facilities) or activities instead of functional departments. Budgets are compiled as if the programmes are being launched for the first time – Projected expenditure for existing programmes should start from zero. www.bournemouth.ac.uk  Zero Budgets Reasons for its lack of success:  Too costly and time-consuming  Insufficient information to support the process  Other organizational and behaviour factors Suited to non-profit organization and discretionary costs (advertising costs; research & development costs) and support activities in profit organizations www.bournemouth.ac.uk  Activity-Based Budgets (ABB) ABB aims to authorize only the supply of those resources that are needed to perform activities required to meet budgeted volumes. Therefore, the starting point for preparing ABB is the cost object by separating indirect costs into homogenous activity cost pools. www.bournemouth.ac.uk  Activity-Based Budgets (ABB) ABB involves a four step process Determine the budgeted cost to perform each unit of activity at each activity area Determine the demand for each individual activity based on budgeted, production, new product development, etc Calculate the cost of performing each activity Describe the budget as cost for performing various activities (rather than budgeted costs of functional or conventional value-chain spending categories). www.bournemouth.ac.uk  Kaizen Budgets Aims at continuously improving processes and reducing costs Concept can be applied to budgeting by incorporating expected cost reductions into the planned results of a business. The concept tends to yield gradual improvements over a long period of time and drive down costs below their current levels on a continual basis Concept requires great planning by management and requires sufficient time and resources to examine all aspects of the business www.bournemouth.ac.uk  Kaizen Budgets Problems associated with Kaizen budgeting: Useful in the first few years to achieve initial reductions. If reductions are not achieved, cash flows and profits too cannot be achieved leading to considerable unfavourable variances in the budget www.bournemouth.ac.uk  Continuous Budgets The traditional annual budgets have been criticised: it is too rigid and based on uncertain forecasts. An alternative approach is to break down the budget by months for the first three months, and quarters for the remaining nine months. As the year proceeds, the quarterly budgets are reviewed and then developed on a monthly basis. By adding and preparing a budget for a fifth quarter, a 12-month budget is always available as the quarter just ended and is dropped – continuous/rolling planning www.bournemouth.ac.uk  Criticism of Budgeting Encouraging rigid planning and incremental thinking; Being time-consuming; Producing inadequate variance reports leaving the ‘how’ and ‘why’ questions unanswered; Ignoring key drivers of shareholders value by focusing too much attention on short-term financial numbers; Being yearly rigid ritual; www.bournemouth.ac.uk  Criticism of Budgeting Tying the company to a 12-month commitment, which is risky since it is based on uncertain forecasts; Meeting only the lowest targets and not attempting to beat the targets; Spending what is in the budget even if this is not necessary in order to guard against next year’s budget being reduced; www.bournemouth.ac.uk www.bournemouth.ac.uk  Reading List Drury & Tayles (2023), Management & Cost Accounting, 12th Edition, Chapter 15 www.bournemouth.ac.uk