Budgeting: A Guide to Mastering Financial Planning PDF

9-3 The Basic Framework of Budgeting A budget is a detailed quantitative plan for acquiring and using financial and other resources over a specified forthcoming time period. 1. The act of preparing a budget is called budgeting. 2. The use of budgets to control an organization’s activities is known...

9-3 The Basic Framework of Budgeting A budget is a detailed quantitative plan for acquiring and using financial and other resources over a specified forthcoming time period. 1. The act of preparing a budget is called budgeting. 2. The use of budgets to control an organization’s activities is known as budgetary control. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 3 A budget is a detailed quantitative plan for acquiring and using financial and other resources over a specified forthcoming time period. The act of preparing a budget is called budgeting. The use of budgets to control an organization’s activities is known as budgetary control. 3 9-4 Planning and Control Control – Planning – involves developing objectives and preparing various budgets to achieve those objectives. McGraw-Hill Education (Asia) McGraw-Hill/Irwin involves the steps taken by management to increase the likelihood that the objectives set down while planning are attained and that all parts of the organization are working together toward that goal. Garrison, Noreen, Brewer, Cheng & Yuen Slide 4 Planning involves developing objectives and preparing various budgets to achieve those objectives. Control involves the steps taken by management to increase the likelihood that the objectives set down at the planning stage are attained and that all parts of the organization are working together toward that goal. To be effective, a good budgeting system must provide for both planning and control. Good planning without effective control is time wasted. 4 9-5 Advantages of Budgeting Define goals and objectives Communicate plans Think about and plan for the future Advantages Coordinate activities Means of allocating resources Uncover potential bottlenecks McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 5 Budgets communicate management’s plans throughout the organization. Budgets force managers to think about and plan for the future. The budgeting process provides a means of allocating resources to those parts of the organization where they can be used most effectively. The budget process can uncover potential bottlenecks before they occur. Budgets coordinate the activities of the entire organization by integrating the plans of its various parts. Budgets define goals and objectives that can serve as benchmarks for evaluating subsequent performance. While our focus in this chapter is on preparing operating budgets for a one-year time frame, longer term budgets also can be very helpful to organizations from a planning standpoint. 5 9-6 Responsibility Accounting Managers should be held responsible for those items - and only those items - that they can actually control to a significant extent. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 6 The premise of responsibility accounting is that managers should be held responsible only for those items that they can control to a significant extent. Responsibility accounting systems enable organizations to react quickly to deviations from their plans and to learn from feedback obtained by comparing budgeted goals to actual results. The point is not to penalize individuals for missing targets. 6 9-7 Choosing the Budget Period Operating Budget 2011 2012 Operating budgets ordinarily cover a one-year period corresponding to a company’s fiscal year. Many companies divide their annual budget into four quarters. McGraw-Hill Education (Asia) McGraw-Hill/Irwin 2013 2014 A continuous budget is a 12-month budget that rolls forward one month (or quarter) as the current month (or quarter) is completed. Garrison, Noreen, Brewer, Cheng & Yuen Slide 7 Part I Operating budgets ordinarily cover a one-year period corresponding to a company’s fiscal year. Many companies divide their annual budget into four quarters. In this chapter, we focus on one-year operating budgets. Part II A continuous or perpetual budget is a 12-month budget that rolls forward one month (or quarter) as the current month (or quarter) is completed. This approach keeps managers focused on the future at least one year ahead. 7 Bottom-up and Top-down Budgeting Bottom-up budgeting (Self-imposed budget or Participative budget ) Top-down budgeting Top Management Top Management Middle Management Middle Management Lower-level Management Lower-level Management McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 9 Bottom-up budgeting The initial flow of budget data in a bottom up budgeting system is from lower levels of management to higher levels of management. Each person with responsibility for cost or revenue will prepare his or her own budget estimates and submit them to the next higher level of management. These estimates are reviewed and consolidated as they move upward in the organization. Therefore, it is also called a self-imposed budget or participative budget that requires the full cooperation and participation of managers at all levels. It is a particularly useful approach if the budget will be used to evaluate managerial performance. Top-down budgeting Top management sets all the key targets for the entire company. These key targets are then move downwards for the middle and lower-level management to come up with other detailed budgeted figures. Under this approach, middle and lower-level management are tasked to complete the budget plan towards meeting the key targets set by the top management. 9 9-10 Advantages of the Bottom-up Budgeting (Self-Imposed Budgets) 1. Individuals at all levels of the organization are viewed as members of the team whose judgments are valued by top management. 2. Budget estimates prepared by front-line managers are often more accurate than estimates prepared by top managers. 3. Motivation is generally higher when individuals participate in setting their own goals than when the goals are imposed from above. 4. A manager who is not able to meet a budget imposed from above can claim that it was unrealistic. Self-imposed budgets eliminate this excuse. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 10 The key to self-imposed budgets is to get operational managers involved in the budgeting process and to clearly state their goals and expectations. Here is a list of four major advantages of self-imposed budgets. First, individuals at all levels of the organization are viewed as members of the team whose judgments are valued by top management. Second, budget estimates prepared by front-line managers (who have intimate knowledge of day-to-day operations) are often more accurate than estimates prepared by top managers. Third, motivation is generally higher when individuals participate in setting their own goals than when the goals are imposed from above. Fourth, a manager who is not able to meet a budget imposed from above can claim that it was unrealistic. Self-imposed budgets eliminate this excuse. 10 9-11 How to overcome problems of selfimposed budgets Self-imposed budgets should be reviewed by higher levels of management to prevent “budgetary slack (or budget padding).” Most companies issue broad guidelines in terms of overall profits or sales. Lower level managers are directed to prepare budgets that meet those targets. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 11 Self-imposed budgets should be reviewed by higher levels of management. Without such a review, self-imposed budgets may have too much “budgetary slack,” or may not be aligned with overall strategic objectives. Most companies do not rely exclusively upon self-imposed budgets in the sense that top managers usually initiate the budget process by issuing broad guidelines in terms of overall target profits or sales. Lower level managers are directed to prepare budgets that meet those targets. 11 Advantages of the Top-down Budgeting 1. Avoid the potential budgetary slack (budget padding). 2. Provide a clearer performance goals and expectations from the top management. 3. May provide better budget due to top management’s access to privileged/confidential market and organization information . 4. Provide an efficient budgetary process. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 12 Problems of self-imposed budget can be solved by the top-down budgeting approach. For example, it can: 1.avoid the potential budgetary slack (budget padding). 2.provide a clearer performance goals and expectations from the top management. 3.provide better budget due to top management’s access to privileged/confidential market and organization information . 4.provide an efficient budgetary process. 12 Budget Lapsing • A popular method among government agencies, universities and organizations relying on allocated funds. • Any unused funding at the end of the financial period cannot be carried forward to the following year. • As a result, the following year’s budget may be cut because of the under-expenditure in the previous year. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 13 • A popular method among government agencies, universities and organizations relying on allocated funds. • Any unused funding at the end of the financial period cannot be carried forward to the following year. • As a result, the following year’s budget may be cut because of the underexpenditure in the previous year. 13 Budget Lapsing: Advantages • Budget lapsing helps ensure that the appropriate level of resources is utilized in each period. Without budget lapsing, risk-averse managers may unnecessarily accumulate funds and this may adversely affect the performance of the organization. • It helps provide an opportunity for a clean cut-off of expenditures and to reallocate any unused resources for other more appropriate requirements. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 14 Budget Lapsing: Advantages • Budget lapsing helps ensure that the appropriate level of resources is utilized in each period. Without budget lapsing, risk-averse managers may unnecessarily accumulate funds just in case of any sudden fund requirements. Unnecessary savings from, for example, essential repair and maintenance, may adversely affect the organization. • It helps provide an opportunity for a clean cut-off of expenditures and to reallocate any unused resources for other more appropriate requirements. 14 Budget Lapsing: Potential Problem & Solution • Budget lapsing can cause undesired behavior effects. For example, managers may wastefully spend their entire budget before the end of the period in order to avoid budget cuts. • A system of reviewing the expenditures near end of the period may uncover unnecessary expenditures and discourage managers to wastefully spend because of budget lapsing. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 15 Budget Lapsing: Potential Problem & Solution • Budget lapsing can cause undesired behavior effects. For example, managers may wastefully spend their entire budget before the end of the period in order to avoid budget cuts. • A system of reviewing the expenditures near end of the period may uncover unnecessary expenditures and discourage managers to wastefully spend because of budget lapsing. 15 Incremental versus Zero-based Budgets • Incremental method of budgeting is most commonly used by companies. Companies start off one year’s budget by referring back to the previous year’s figures. Adjustments are then made to the budget to account for the expected changes such as prices for the next year. • While incremental method of budgeting is practical and fast, any inefficiency in the previous year’s figures may be carried forward. For example, if all along the organization is over staffed, then the budget will continually to be allowing for the over staffing situation under this method. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 16 • Incremental method of budgeting is most commonly used by companies. Companies start off one year’s budget by referring back to the previous year’s figures. Adjustments are then made to the budget to account for the expected changes such as prices for the next year. • While incremental method of budgeting is practical and fast, any inefficiency in the previous year’s figures may be carried forward. For example, if all along the organization is over staffed, then the budget will continually to be allowing for the over staffing situation under this method. 16 Incremental versus Zero-based Budgets • Zero-Based Budgets are prepared based on the assumption that the company has just started. Therefore, resources required have to be justified from scratch. • For example, when budgeting for staff cost for a restaurant, managers using the zero-based budgeting approach will ignore the existing staff level and expenses, rather, they will examine factors such as opening hours, number of tables, expected patron numbers to work out the number of staff required at each position and level, hence the associate costs, to produce a budget. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 17 • Zero-Based Budgets are prepared based on the assumption that the company has just started. Therefore, resources required have to be justified from scratch. • For example, when budgeting for staff cost for a restaurant, managers using the zero-based budgeting approach will ignore the existing staff level and expenses, rather, they will examine factors such as opening hours, number of tables, expected patron numbers to work out the number of staff required at each position and level, hence the associate costs, to produce a budget. 17 Incremental versus Zero-based Budgets • Companies using the zero-based method do not simply ignore previous years’ figures. Figures generated by the zero-based method are usually compared with previous years’ figures. Any large differences are investigated. • As zero-based budgeting is time consuming and costly, companies tend to use this method for the relatively large items and the incremental method for the rest. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 18 • Companies using the zero-based method do not simply ignore previous years’ figures. Figures generated by the zero-based method are usually compared with previous years’ figures. Any large differences are investigated. • As zero-based budgeting is time consuming and costly, companies tend to use this method for the relatively large items and the incremental method for the rest. 18 9-19 Top Management Attitude: Human Factors in Budgeting The success of a budget program depends on three important factors: 1. Top management must be enthusiastic and committed to the budget process. 2. Top management must not use the budget to pressure employees or blame them when something goes wrong. 3. Budget targets should be challenging but achievable in order to have good motivational effects. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 19 The success of a budget program depends upon three important factors: 1.Top management must be enthusiastic and committed to the budget process, otherwise nobody will take it seriously. 2.Top management must not use the budget to pressure employees or blame them when something goes wrong. This breeds hostility and mistrust rather than cooperative and coordinated efforts. 3.Budget targets should be challenging but achievable in order to have good motivational effects. 19 9-20 The Budget Committee A standing committee responsible for  overall policy matters relating to the budget  coordinating the preparation of the budget  resolving disputes related to the budget  approving the final budget McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 20 A budget committee is usually responsible for overall policy relating to the budget program, for coordinating the preparation of the budget, for resolving disputes related to the budget, and for approving the final budget. This committee may consist of the president and the vice presidents in charge of various functions such as sales, production, purchasing, and the controller. 20 Understand the key components of master budget in Manufacturing, Merchandising, and Service Industries The first step of budgeting for every business is to budget for the revenue, whether it is a sales budget for providing goods or services or a funding budget. Although operational budgets are adapted according to the industries, they are very similar and typically comprise of budgets for • Income statement • Cash • Balance sheet. The major differences of different industries include: • Manufacturing: production budget is involved • Merchandising: no production budget, only purchase budget of merchandise is required. • Service Industries: budget for revenue and cost of providing services • Not-for-profit: expected funding available and plan usage of funding. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 22 The master budget consists of a number of separate but interdependent budgets that formally lay out the company’s sales, production, and financial goals. The master budget culminates in a cash budget, a budgeted income statement, and a budgeted balance sheet. Exhibit 10-2 provides an overview of the various parts of the master budget and how they are related. Companies in different industries adapt this master budget based on their particular needs. For a manufacturer, the first step in the budgeting process is the preparation of the sales budget, which is a detailed schedule showing the expected sales for the budget period. An accurate sales budget is the key to the entire budgeting process as all other budgets such as the production budget and the income statement budget depend on the sales budget. The sales budget is compiled by taking into account, for example, past sales levels, general economic trends, competitors’ actions and pricing strategies. Once the sales budget is done, a manufacturer will do the production budget based on the sales budget and the required finished goods inventory. Finished goods inventory is necessary to cater for any unexpected change in demand. Thereafter, the production budget is utilized to determine the budgets for direct materials, direct labor and manufacturing overheads. A budget for selling and administrative expenses will then be prepared. Finally, budgeted cash statement, income statement and balance sheet are compiled. For a merchandiser, the first step is also the preparation of the sales budget. After the sales budget, a merchandiser will do a budget for the merchandise purchases. The sales budget and the inventory required are utilized to compile the budget for merchandise purchases. Production, direct materials, direct labor and manufacturing overhead budgets are not applicable for a merchandiser. Similar to a manufacturer, other budgets including selling and administrative expenses, cash, income statement and balance sheet are prepared. For a service provider, same as a manufacturer or a merchandiser, a sales budget is done first. The sales budget gives details of the services to be provided and the related income. Based on the sales budget, other budgets are then prepared. To most service providers, human capital (or human resources) budgeting/planning could be one of the most important budget after sales budget. A not-for-profit organization budget has many similarities with other organizations. The major difference is that this organization normally does not charge for its goods and services. Instead, funding is obtained from government bodies or donors. Therefore, there is no sales budget for a not-for-profit organization. Instead, it will have a budget for revenue or funding. From this budget, the organization will then plan for its activities accordingly by producing a budget for activities and expenses. Therefore, the first step of budgeting for every business is to budget for the revenue, whether it is a sales budget for providing goods or services or a funding budget. Although operational budgets are adapted according to the industries, they are very similar and typically comprise of budgets for income statement, cash and balance sheet. We will next describe the detailed budgeted information for a manufacturer. 22 9-24 The Master Budget: An Overview Sales budget Ending inventory budget Direct materials budget Production budget Direct labor budget Selling and administrative budget Manufacturing overhead budget Cash Budget Budgeted income statement McGraw-Hill Education (Asia) McGraw-Hill/Irwin Budgeted balance sheet Garrison, Noreen, Brewer, Cheng & Yuen Slide 24 The master budget consists of a number of separate but interdependent budgets. We have developed this schematic of the budgeting process to illustrate the interdependency of the various individual budgets. The sales budget shows the expected sales for the budget period expressed in dollars and units. It is usually based on a company’s sales forecast. All other parts of the master budget are dependent on the sales budget. The production budget is prepared after the sales budget. It lists the number of units that must be produced during each budget period to meet sales needs and to provide for the desired ending inventory. The production budget in turn directly influences the direct materials, direct labor, and manufacturing overhead budgets, which in turn enable the preparation of the ending finished goods inventory budget. These budgets are then combined with data from the sales budget and the selling and administrative expense budget to determine the cash budget. The cash budget is a detailed plan showing how cash resources will be acquired and used over a specified time period. All of the operating budgets have an impact on the cash budget. The last step of the process is to prepare a budgeted income statement and a budgeted balance sheet. 24 9-36 The Production Budget Sales Budget and Expected Cash Collections Production Budget The production budget must be adequate to meet budgeted sales and to provide for the desired ending inventory. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 36 After we have budgeted our sales and expected cash collection, we must make sure the production budget is adequate to meet the forecasted sales and to provide for the desired ending inventory. We need inventory on hand at the end of the period to minimize the likelihood of an inventory stock-out. 36 9-45 Format of the Cash Budget The cash budget is divided into four sections: 1. Cash receipts section lists all cash inflows excluding cash received from financing; 2. Cash disbursements section consists of all cash payments excluding repayments of principal and interest; 3. Cash excess or deficiency section determines if the company will need to borrow money or if it will be able to repay funds previously borrowed; and 4. Financing section details the borrowings and repayments projected to take place during the budget period. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 45 The preparation of the cash budget can be quite complex. This budget should be broken down into time periods that are as short as feasible. It consists of four major sections: 1.Cash receipts section lists all cash inflows excluding cash received from financing; 2.Cash disbursements section consists of all cash payments excluding repayments of principal and interest; 3.Cash excess or deficiency section determines if the company will need to borrow money or if it will be able to repay funds previously borrowed; and 4.Financing section details the borrowings and repayments projected to take place during the budget period. 45 Costs and Benefits of Budgeting • Budgeting is time-consuming and costly. • Budgetary slack or padding is an inherent problem of budgeting. • Despite the drawbacks of budgeting, most companies are still using budgets to plan, communicate, set objectives and allocate resources etc. • Since budgets are still commonly used, benefits of budgeting are high and drawbacks of budgeting can be minimized by having a good budgeting system. • For a good budgeting system, it is critical to have effective communication and mutual trust between the top management and its staff. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 56 • Budgeting is time-consuming and costly. • Budgetary slack or padding is an inherent problem of budgeting. • Despite the drawbacks of budgeting, most companies are still using budgets to plan, communicate, set objectives and allocate resources etc. • Since budgets are still commonly used, benefits of budgeting must be high and drawbacks of budgeting can be minimized by having a good budgeting system. • For a good budgeting system, it is critical to have effective communication and mutual trust between the top management and its staff. 56