Budgeting PDF

Chapter 9 Budgeting ©2020 John Wiley & Sons Australia Ltd  Learning objectives After studying this presentation, you should be able to: 9.1 understand the importance of planning and budgeting 9.2 explain what a budget is and describe the key steps in the budgetin...

Chapter 9 Budgeting ©2020 John Wiley & Sons Australia Ltd  Learning objectives After studying this presentation, you should be able to: 9.1 understand the importance of planning and budgeting 9.2 explain what a budget is and describe the key steps in the budgeting process 9.3 explain the different types of budgets 9.4 outline the components of a master budget and prepare a master budget  Learning objectives 9.5 prepare a schedule of receipts from accounts receivable and a cash budget 9.6 explain the use of budgeting in planning and control 9.7 discuss the issues associated with the behavioural aspects of budgeting.  Strategic planning and budgeting Strategic planning concerns longer term planning (typically, 3–5 years). It is usually carried out by senior management. It commonly relates to broader issues such as business takeovers, expansion plans, deletion of business segments and radical product/service development.  Strategic planning and budgeting Budgeting is a process that focuses on the short term, commonly one year, and results in the production of budgets that set the financial framework for that period. Budgets operationalise strategic plans and allow operational areas to understand how their area contributes to the entity’s strategic objectives. Strategic planning and budgeting  Budgets Entities engage in a planning process that requires involvement in a budgeting process. Part of the formal planning process relates to an entity’s operational plans, including short term goals and targets. Performance management involves setting targets in other than just financial terms (e.g. improving customer service, corporate governance, management techniques and human resource management).  Budgets A budget is the quantitative expression of an entity’s plans. Budgeting can assist in decision making by: – putting into operation longer term plans – assessing the feasibility of strategic plans – setting targets for managers – identifying resource constraints in budget period – identifying periods of expected cash shortages and excess cash holdings – assisting with short-term planning decisions  Budgets – providing profit forecasts and other financial data to the capital markets – forecasting data such as sales or fees, which commonly set the level of activity for the budget period – helping determine required inventory levels and purchasing requirements for raw materials – planning labour and other inputs – determining the ability of the entity to meet financing commitments.  The budgeting process The budgeting process is a process involving evaluating past performance, assessing and incorporating expectations, preparing estimates, and monitoring and adjusting budgets as required by changing circumstances. Involves a series of steps.  Steps in the budgeting process 1. Consideration of past performance 2. Assessment of expected trading and operating conditions 3. Preparation of initial budget estimates 4. Adjustment to estimates based on communication with, and feedback from, managers 5. Preparation of budgeted reports and sub-budgets 6. Monitoring of actual performance against the budget over the budget period 7. Making any necessary adjustments to the budget during the budget period.  The budgeting process Throughout the process, communication with managers who are affected by the budgets should occur. Simons (2000) highlights the need for those within the entity to work together to develop the profit plan for the coming year. The interaction of the various personnel enables them to understand the impact of their decisions and to assess whether value is created for the entity.  Types of budgets Sales (or fees) budget — sets expected levels of activity. Operating (expenses) budget — often departmental expense budgets. Production and inventory budgets (for manufacturing entities) — for planning production levels and managing inventory levels; often include sub-budgets relating to direct materials, direct labour and indirect costs etc. Purchases budget — sets the required purchases of inventory or direct materials based on sales budget (and possibly the production/inventory budgets).  Types of budgets Manufacturing overhead budget — focuses on estimating overheads or expenses associated with production activities. Budgeted statement of profit or loss — an aggregation of the other sub-budgets such as sales budget and operating expenses budget. Cash budget — a statement of expected future cash receipts and cash payments. Budgeted statement of financial position — assets and liabilities at end of period.  Types of budgets Capital budget — focuses on expenditure relating to long-term investments. Program budget — a budget form commonly used in the government and not-for-profit sector, where the focus is on costs associated with a specific program. Applicable budgets for sample entities  Example – Production Budget Question 2 X-treme Bike Ltd expects to sell 25,000 electronic bicycles next year. The management estimates that the beginning and ending inventory will be 2,000 units and 3,500 units, respectively. Required: Prepare a production budget for next year. Example – Production Budget Example: Direct Material Budget Example: Direct Material Budget Example: Cash Collection Budget Example: Cash Collection Budget  Master budget A master budget is a set of interrelated budgets for a future period which provides a framework for viewing relevant budgets of an entity. To enable the budget to be used as a control tool to monitor the entity’s achievement of its plans, classification of items included in the master budget needs to mirror the entity’s chart of accounts. The chart of accounts is a detailed listing/index that guides how transactions will be classified and recorded in the financial reporting system.  Master budget Because budgets are based on forecasts about the future, complete accuracy is impossible and variances will inevitably arise. A variance is the difference between actual and budget results, and it can be either favourable or unfavourable. A favourable variance occurs when actual revenues are larger than budgeted, or actual costs are lower than budgeted. Conversely, an unfavourable variance arises when actual revenues are lower than budgeted, or actual costs are greater than budgeted. Master budget  Master budget The preparation of an operating budget for a service entity requires market analysis to identify customers’ demand. This will lead to the preparation of the sales budget detailing the estimated revenue that will be generated based on forecast demand.  Master budget Preparation of an operating budget for a manufacturing entity involves: – developing the sales budget – developing the production budget – developing the materials budget – developing the labour budget – developing the production overhead budget and the selling and administrative expense budget.  The cash budget The cash budget is a statement of expected future cash receipts and payments. The cash budget assists decision making by: – documenting timing of all cash receipts and payments – helping to identify periods of expected cash shortages and surpluses – identifying suitable times for purchase of non-current assets  The cash budget The cash budget assists decision making by: – assisting with planning and use of borrowed funds – providing a framework for ‘what if’ analysis. For an entity that provides goods or services on credit, one of the main tasks in the preparation of a cash budget is calculating the cash receipts from the credit sales or fees generated. This is commonly shown in a schedule of receipts from debtors/accounts receivable. Prepare a schedule of receipts from accounts receivable and other sub-budgets Prepare the cash budget  Budgets: planning and control The preparation of the cash budget is an important part of the planning process. It can then be used for monitoring cash performance, also known as the control process. A cash budget prepared on a month-by-month basis is much more useful for this purpose than one prepared on a quarterly or yearly basis. As each month passes, the actual cash numbers can be compared to the budget numbers. The difference between the two is called a variance. Variance report (example)  Improving cash flow Cash inflow may be increased by: – improving the collections of cash from debtors – seeking ways to improve sales or fees – reducing unnecessary stock levels – arranging external finance – providing an extra capital contribution from the owners, or considering a change in ownership structure – selling excess non-current assets.  Improving cash flow Cash outflow may be reduced by: – cutting expenses by identifying areas of waste, duplication or inefficiency – making use of creditors’ terms – keeping inventory levels to only what is required, as excess inventory ties up cash and often adds to storage and handling costs – deferring capital expenditures – reducing carbon footprint.  Behavioural aspects of budgeting The behavioural aspect of budgeting and planning seeks to explore two key areas: 1. relates to the ‘style’ of budgeting process used by the organisation, such as the extent of participation by managers in the annual budget process 2. relates to the impact of the budget targets and plans on the behaviour, motivation and decision making of the manager.  Styles of budgeting – In an authoritarian style of budgeting: senior management simply sets the targets and the budget for unit managers unit managers have little say in the targets that are set.  Styles of budgeting – In a participative style of budgeting: targets and budgets are arrived at by a process of discussion and negotiation between senior management and unit managers unit managers are seen to have had a say in the setting of targets and the budget.  Effect of budget targets on behaviour How motivated a manager might be regarding budget targets is influenced by a range of factors, including: – budget targets are best set as challenging but attainable – whether the manager feels ‘ownership’ of the target – whether the manager is able to control the factors influencing the achievement of the budget target – whether the budget estimates provide too little scope for managers to properly execute their duties.  Summary Strategic planning influences shorter term aspects of the budgetary planning process. A master budget may be viewed as a set of interrelated budgets for a future period. A master budget is commonly classified into a set of operating budgets and financial budgets. The behavioural aspects of budgeting relate to the human involvement in decision making.