Budgeting Lecture Notes

Group Assignment

• Due on Monday, May 19.
• Consultation opportunities were provided to clear up questions with tutors.
• The submission portal will be open a few days before the deadline.
• Submit the final version to avoid issues with incorrect submissions.
• The cover page should only include the names of students who contributed to the assignment.
• Names on the cover sheet will be checked against contribution to ensure fair marking.
• Inform the instructor ahead of time about non-contributing group members (freeloaders) so it can be considered during marking.
• Each group receives one mark.
• Students should carefully review the document before submission.
• One to two students should review the document before submission.

Test 2

• Marking is in progress.
• Results will be released early next week.
• An announcement will be posted when marks are available.
• Students can approach the instructor or tutor to review their paper and receive feedback for final exam preparation.

Module Quizzes

• Budgeting module quizzes opened today.
• Cost volume profit analysis (Topic 7) quizzes close this week on Friday.
• Budgeting module quizzes are available for two weeks starting today.

Budgeting: Cost Planning and Control

• Budgeting is a key topic that is usually included in exams.
• A budget is:
  • Allocation of funds.
  • Planning money
  • Minimize costs
  • Safety
  • A limit guide
  • Informative
  • Spending limit
  • Money planning
• Planning is a very common response.
• Using a budget:
  • It can work.
  • It's a guide if you follow it.
  • Depends on the discipline of the user.
  • Most of the time, it can work if you follow it.
  • Good guideline.
  • Guides you on how to spend funds or operations.
  • Yes, if you stick with it; yes, if your budget is large enough to cover unexpected costs.
  • Yes, provided it's realistic and followed.
• The lecture will cover:
  • How a budget works in an organization.
  • What can be learned from using a budget from an accounting perspective.
  • Different tools that can be used to prepare a budget.
  • How to evaluate if a budget is effective.

Goals of Budgeting Discussion

• Describe the budget development process.
• Understand behavioral implications.
• Identify advantages of budgeting.
• Explain the master budget.
• Differentiate between static and flexible budgets.
• Explain the concept of rolling budgets.
• Explain the interpretation of variances.

What is Budgeting?

• Budgets are plans dealing with acquisition and use of resources over a specified period.
• Budgets are quantitative expressions of an entity's plans, expressed in financial or monetary terms.
• It's not just about planning before something happens but also after.
• Budgeting encompasses three aspects:
  • Planning: Helps develop and refine goals and objectives.
  • Operating: Execution of the plan in day-to-day activities and decisions.
  • Controlling: Comparing planned versus actual results to monitor performance; how good are we in terms of sticking with the budget.

Operating Cycle of a Business

• It guides activities that would be essential in preparing or considering a budget.

Planning Aspect of Budgeting

• Businesses have objectives or different goals like:
  • Expansion of markets.
  • Earning a specific profit.
  • Developing a product.
• A plan is essential because it sets the direction in terms of where the business intends to go.
• Plans could be both short term (one year or less) or long term (five years, three years).
• Strategic plans covers future direction of the business:
  • Markets that the business aims to serve.
  • Organizational processes.
  • Levels of profit sought.
  • Personal and other requirements.
• A budget is a financial plan for a future time.
• A budget forces an organization to express its plans quantitatively and it converts the long-term plan into an actionable blueprint for the future.
• It compels an organization to have a more realistic outlook of the plans.
• Lacking of adequate planning for cash needs destines small businesses for failure.
• Spreadsheets and softwares provide practically no excuse in terms of being able to coming up with a budget these days.

Budget Development Process

• Budgeting is much more than a number crunching exercise. Right?
• It is a management task that requires a great deal of planning and input from a broad range of managers in a company. So it's not just about computing or getting the numbers right. It is an activity that involves a lot of coordination and planning from different individuals and different units in a business.
• Budgeting, everyone, is not an exercise for one person. Remember, if you're budgeting for an entire organization, you need to consider different departments, different units, different individuals. Right? So it's not just preparing the numbers, but it's working together, right, as a unit or as a group so that you could gather the inputs and create a plan that you would be adhering.
• Consideration of past performance.
• Assessment of the expected trading and operating conditions.
• Preparation of initial budget estimates.
• Adjustment to estimates based on communication with and feedback from managers.
• Preparation of the budgeted reports and any sub-budgets.
• Monitoring of actual performance against the budget over the budget period.
• Making adjustments to the budget during the period.

Approaches to Budgeting

Incremental Budgeting

• Budgets are based on what happened in the previous year with adjustments made for expected future events.
• Use last year's budget, and then make changes to specific items that you think will be affected by changes in conditions.
• The benefit of this is that it's easy; it's straightforward to prepare.
• Saves you time because you can easily have a budget in a short amount of time because you're just looking at the increments, the changes.
• Trade-off: This process assumes that current activities and costs are still needed without examining them.

Zero-Based Budgeting

• Managers are required to build budgets from the ground up; meaning, you start from scratch.
• You don't use anything from last year; we start from a clean slate and then prepare the budget from there.
• Managers will justify all items in the budget.
• During the pandemic, companies switched to zero-based budgets, as illustrated in one article shared.
• It's an expense management strategy that requires finance executives to question and justify each line item in their budget.
• The disruptions of COVID are causing people and companies to fundamentally rethink parts of their budget.

Rolling Budget

• Usually, an organization would prepare a budget for a full year.
• A company would use monthly budgets and rolling twelve-month budgets to provide a mechanism for adjusting in response to unforeseen circumstances.
• For example, prepare an annual budget divided in terms of quarters. Initial budget is year one with quarter one, two, three, and four.
• Once the first quarter is done, the budget updates for the second quarter begins with quarter two, three, and four plus quarter one of next year.
• It's dynamic because it's not just fixated on a specific period.
• As one period expires, the budget is being updated with new information, assumptions, and circumstances so that the most recent period added is updated, and you could also see potential changes.
• This is not only done on a per-quarter basis. You can also prepare a rolling budget on a month-to-month basis.

Approaches to Budgeting

Top-Down Approach

• Top management prepares a budget and imposes it on everyone.

Participative Approach to Budgeting

• It is a bottom-up approach to budgeting where people on the ground, such as departmental managers, are involved.
• The starting point would be departmental managers, and what happens is that, from the departmental managers, it flows up to middle managers.
• At each level, budget estimates are prepared and submitted.
• Budgets are effective if people who are responsible for carrying out plans and whose performance will be measured against the outcome of these plans participate in the process of budget development.
• When you give people a voice or a say in terms of the budget development process, it somehow gives them a sense of ownership.
• Participatory budgeting is more motivational in a sense so that individuals are encouraged and motivated to work towards a common goal.

Budgeting Process

• Is guided by a strategic plan.
• Integrates individual budgets。
• Motivates employees to meet goals.
• Helps structure reward systems.

Behavioral Implications if Budgeting is Used for Planning and Control

• Managers who must meet the budget have incentives to pad it so that targets are easier to reach; there is the creation of a slack.
• If managers are paid or compensated based on targeted budgets, they may shift revenues and expenses across periods.
• There is a potential goal congruence issue if budgets are used for planning and control purposes because their priority is to achieve their own reward system, their own incentives, and not the business as a whole.

Advantages of Budgeting

• Compels communication throughout the organization.
• Forces a future focus.
• Helps identify bottlenecks and constraints.
• Increases coordination and goal congruence.
• Defines goals and objectives as standards of performance.

Manufacturing Master Budget

• It is a collection of operating and financial budgets:
  • Sales budget.
  • Production budget.
  • Labor budget.
  • Overhead budget.
  • Cash budget.
  • Budgeted balance sheet.
  • Budgeted income statement.
• It's the overall plan or overall budget for the entire organization.
• Explicitly demonstrates why coordination and communication are important in the budgeting process.
• Requires coordination and alignment with everyone, not done in silos or in isolation.
• There is a flow-on effect, and one budget affects another.

Sales Budget

• You need to have a sales forecast.
• It's used in overall strategic planning.
• It is used in planning for the cash needs of the business.
• It’s important to prepare it first because among all other things, the sales budget involves external factors.
• All other budgets are affected by the sales budget.
• Factors that can influence sales forecasts:
  • Historical data.
  • General economic trend.
  • Regional and local factors.
  • Anticipated price changes for purchasing and sales costs.
  • Anticipated marketing and advertising plans.
  • The impact of new products, technology, or process change.
  • Other factors such as political and legal events.

Budgeting as a Control Mechanism

• In controlling, the focus now is to evaluate performance; what happened versus what we planned.

• Comparison of actual performance against planned outcomes.

• Provides accountability in an organization toward the plans that they have made versus the actual results.

• Identify variances, which is the difference between actual and planned outcomes.

• A variance could either be favorable or unfavorable.

• It enables businesses to make adjustments and ensures that they are on track toward attaining objectives.
  Part of controlling is management by exception:

  • You only take action when actual results deviate significantly from planned.
  • If the deviation or the difference is material, significant, or too much, then that's the time you scrutinize it.

Management By Exception

• Example given is of Henry Incorporated where
  • Revenues: Only report to the chief financial controller if the revenues fall below 50% of the annual business plan.
  • Expenses: Only report to the chief financial controller if expenses exceed 50% of the annual business plan.
• Sales and expenses for the year were budgeted at 10,000,000 and 7,000,000 respectively.
• Actual sales and expenses as of the third quarter were 6,000,000 and 4,000,000.
• The task is to determine whether the matter needs to be reported to the chief financial controller.

Static vs. Flexible Budgets

• Static budget is established at the beginning of the period for one activity level.
• Helpful for planning and operating purposes.
• Flexible budget reflects costs that would have been expected for the actual activity.
• Uses actual, not planned activity levels.
• It is prepared not at the beginning of the period, but at the end.
• You want to compare actual results against planned level of activity.
• It takes out differences in cost due to volume differences by budgeting based on actual production.
• Static budgets - Helpful for planning and operating, but not for controlling.
• Flexible budgets - More useful for controlling purposes.

Example

• Planning for a birthday, the plan is to have 200 guests and the budget is 50 each (total 10,000)

• On the actual party, 250 guests attended (spent 11,500).

• But the comparison is not an apple-to-apple comparison because you're comparing 200 versus 250.

• The flexible budget is 50 per guest. Multiply it by the actual number of people attended ( 250)

  • Calculate it on your device ( 250 * 50, that should give you around 12,500).

• Flexible Budget 12,500; you actually spent 11,500 is a good comparison because you saved.

• If we just compare a static budget with the actual results, the results can be misleading:

  • The difference due to volume, comparison is not accurate

• This means if we do a flexible budget, you have 5000 units in terms of same results. Right, Glaring difference Right, but with same units we have good analysis results can be attributed what.

• Cost reduction: You will earn the actual data accurate. but You take what what'.

Controlling: Other Inputs

• Historical Data

  • Historical data can be useful in forecasting future prices and quantities.
  • Helpful inputs that could be used for budgeting purposes for planning and eventually control.
  • Must be used in caution because there might be changes in manufacturing processes, product designs, and operations that might distort historical information.

• Task Analysis

• Look at the processes that are being undertaken to produce a good or service.

• Determine what it should cost to produce the product, not what it cost last year.

• Consider the actual work that needs to be done so that the good is produced.

• Combine task analysis and historical data to determine costs accurately.

Variances

• Good decisions would require, take note, an accurate definition of the problem with inputs across different areas of a business.

• Need to understand what's the goal of the business: Are we trying to control costs, like minimize the costs of our products, or are we trying to improve product quality?

• If we kknow the goal of the business, we can easily interpret: Is this a good thing or a bad thing?

• It will help you to see the Goal Objective

• Identifying management objectives is important when you interpret variances:

  • Cost control
  • or high quality product?

• An increase in costs may be justified if we want to improve product quality.

• Once managers are sure of the root cause of the variance, they can consider options to deal with the problem.

Behavioral Considerations on Variances

• People could be demotivated
• There might be negative implementations if wee only look at variances itself
• Variance analysis is just one measure of performance: it's just one of the inputs.

Behavioral Considerations In Addition

• It existence of Budget May motivate employees to improve perform.
• Demanding but Achievable Targets are More effective and motivating efficiency.
• What you' doing this you you could feel motivate so.
• Participatory budgets allows Managers to to set Targets.

Budgets Will Be Effective - How?

• A Serious attitude from all levels of management
• Clearly defined areas of management responsibility
• Reasonable Budget Targets.
• Establish That Collection and Analysis and Distribution.
• Timely Variance reports Made Available to Managers
• Is action taken to Regain control.