Budgeting Notes

BUDGETING

Learning Objectives

• Define and explain the purposes of a budget.
• Identify the budgeting process and key budget factor.
• Forecast using time series analysis.
• Prepare three types of budget:
  • Functional Budgets
  • Cash Budgets
  • Master Budget
• Explain different techniques of budgeting:
  • Incremental Budgeting
  • Zero-Based Budgeting
  • Rolling Budget
  • Activity-Based Budget

Definition of Budget

• A budget is a detailed plan summarizing the financial consequences of an organization’s operating activities for a specific future time period.
• It can also be seen as a plan of future activities with monetary implications.
• A budget is a financial model that summarizes future operations.
• It's a core component of an organization’s planning and control system.
• It provides information to managers to help them manage resources and create value.
• Budgeting is regarded as short-term planning, typically with a one-year time horizon.
• Budgeting is the process of allocating funds and monitoring actual performance against the budgeted figures.

Purpose of Budget

• Planning annual operations.
• Coordinating the activities of various parts of the organization to ensure harmony.
• Communicating plans to responsibility center managers.
• Motivating managers to achieve organizational goals.
• Controlling activities.
• Evaluating the performance of managers.

Stages in Budgeting Process

1. Communicate details of budget policy and guidelines to those responsible for preparing the budget.
2. Determine the factor that restricts output.
3. Preparation of the sales budget.
4. Initial preparation of budgets.
5. Negotiation of budgets with higher management.
6. Coordination and review of budgets.
7. Final acceptance of budgets.
8. Ongoing review of budgets.

Budget Committee

• The budgeting function is carried out by either the accountant (in a small business) or a budget committee (in a larger company).
• A budget committee typically comprises divisional heads, the chief operating officer, and the group accountant.
• Their major task is to ensure budgets are realistically established and coordinated satisfactorily.

Effective Budgeting

• Sound organizational structure with clearly defined authority and responsibilities.
• Realistic goals.
• Accepted by all levels of management.
• Periodic review of budget with actual performance.
• Corrective actions.

Budget Manual

• The budget manual is a collection of instructions regarding the responsibilities of preparing the budget.
• Its contents include organizational structures and procedures for preparing the budget.

Budget Period

• The budget may be prepared for any period of time depending on the type of budget, nature of the organization, the need for periodic appraisal, and prevailing business conditions.
• The length of budget period varies, but the most common practice is one year.

Principle Budget Factor

• Also known as a limiting budget factor, it arises when there is a short supply of key resources, affecting planning and decision-making.
• Key resources include cash, raw materials supply, labor, or equipment.
• Early identification of this factor is important because it indicates which budget should be prepared first.
• For example, if sales volume is the principal budget factor, then the sales budget must be prepared first, based on available sales forecasts. All other budgets should then be linked to this.

Techniques of Forecasting

Cost Prediction

• Using historical data on costs at various activity levels to arrive at a straight-line relationship between them, which is then extrapolated to forecast costs for future activity levels.
• 5 main methods:
  1. The engineering approach
  2. The account analysis approach (using information in the ledger accounts)
  3. Scatter diagrams
  4. The high-low method
  5. Regression analysis

Time Series

• Relates to a series of values that vary over time. When plotted on a graph, a time series may reveal a trend or relationship.
• Given to a set of observations taken at equal intervals of time.
• Influenced by a number of factors:
  1. Long-term trend (T) – relates to changes in population size/age structure or average income levels.
  2. Cyclical variation (C) – long-term cycles in trade causing demand to rise or fall.
  3. Seasonal variations (S).
  4. Residual or random pattern (R) – variations due to unpredictable causes (e.g., strikes, fire).

Time Series Analysis

• The main reasons for analyzing a time series are:
  • To be able to predict future values of the variables, i.e., to make forecasts.
  • To attempt to control future events.
  • To ‘seasonally adjust’ or ‘deseasonalize’ a set of data. It is a process to remove the seasonal effects.
  • Seasonally adjusted unemployment values are more useful than actual unemployment values in studying the effects of the national economy and government policies on unemployment.

Assumption and Limitations of Time Series Analysis

• Assumption:
  • What has happened in the past can be used to predict what will happen in the future.
• Limitations:
  • Significant changes might occur quickly (e.g., new technology could revolutionize practice and products within an industry).
  • Financial figures collected over a long period of time for time series analysis will be affected by changing price levels.

Preparation of Budgets

Functional or Operating Budget

• These budgets relate to one another; there are 6 types of budget:
  • Sales budget
  • Production budget
  • Direct materials budget
  • Direct labor budget
  • Manufacturing overheads budget
  • Selling & admin expenses budget

Master or Financial Budget

• Summarizes all the functional budgets into the budgeted income statement, cash budget and budgeted statement of financial position:
  • Budgeted income statement
  • Budgeted statement of financial position
  • Cash budget

Preparation of Functional Budget

• The preparation of functional budgets starts with the sales forecasts as the business plans for the expected demand in the next budget period.
• Sales budget: Shows the expected sales likely to be achieved for a certain future period of time.
• Production budget: Shows the expected number of units to be produced incorporating any stock levels to be maintained.
• Direct materials budget: Shows the movement of the raw materials in terms of purchase incorporating a stock level with a net effect of raw materials consumed.
• Direct labor budget: Shows the required direct labor hours with the associated costs.
• Manufacturing overheads budget: Lists the expected manufacturing overheads expenses to be incurred.
• Selling & distribution budget: Provides the expected expenses to be incurred for selling and distribution purposes.

Functional Budgets

• Sales Budget: The first budget to be prepared and is drawn by multiplying the expected unit sales volume for each product by its anticipated unit selling price.
• Production Budget: Once the sales units have been established, the production budget is drawn up to determine the number of units to be produced by considering the stock levels that have to be maintained.
• Materials Usage Budget: Once the production units are set, the material requirement needed to make those products is established based on the type and quantity required. Shows the quantities of materials required to meet the budgeted production.
• Materials Purchase Budget: Taking into account the stock levels required for the materials, the amount of materials to be purchased is determined from the cost of materials to arrive at the total costs involved.
• Direct Labour Budget: Another element of production, direct labor requirement for the production intended must also be set. This is expressed in terms of hours per unit multiplied by the labor rate for the production units.

Sales Budget Example

• Represents the planned level of sales in terms of quantity, mix (if multi-product), and value.

Production Budget Example

• Represents the quantity of product to be produced or manufactured.

Direct Material Budget

• Can be divided into two:

  1. Materials requirement/usage budget
  2. Materials purchase budget

• Example:

Direct Material Usage Budget Example

Direct Material Purchase Budget Example

Direct Labour Budget

• Must be completed to ensure that the company has sufficient labor time to meet the production needs.
• Example: Product A requires 5 direct labor hours per unit. Product B requires 10 direct labor hours per unit. Rate per hour is RM2 for product A and RM3 for product B.

Cash Budget

• Prepared to show the expected receipts and payments of cash during the next period.
• In practice, often prepared for the year on a monthly basis or a quarter for control purposes.
• The longer the period, the less accurate will be the cash forecast.
• Shows expected cash flows of the business.
• The cash flows must be properly managed because if a firm runs out of cash, they might lose a lot of opportunities such as cash discounts, investment, etc.

Objectives of Cash Budget

1. To ensure that sufficient cash is available at all times to meet the level of operations that are outlined in the various budgets.
2. To avoid cash balances that are surplus to its requirement. This will enable the management to take steps in advance to invest the surplus cash in any short term investments.
3. To identify in advance the steps/actions to be taken to meet any temporary cash deficiencies.

Features of Cash Budget

• Contains two sections: Cash Inflow (receipts) & Cash Outflow (payments).
• The cash inflow (receipts) section includes expected receipts from the company’s principal sources of revenues such as cash sales and collections from customers on credit sales.
• The cash outflow (payments) section shows expected payments for direct materials, direct labor, manufacturing overhead and selling and administration expenses.

Format for Cash Budget

Preparation of Master Budget

• Budgeted income statement: Shows the expected profit or loss of the business, detailing the costs and revenues summarized in the functional budgets.
• Budgeted statement of financial position: Shows the expected financial position of the business in terms of the assets owned, capital employed, and liabilities.
• Cash budget: Shows the inflow and outflows of cash movement for receipts and payments respectively, with a balance of either surplus or deficit at the end of each sub-period.

Learning Curve Theory

• The mathematical expression of the commonly observed affect that, as complex and labor-intensive procedures are repeated, unit labor times tend to decrease. The learning curve models mathematically this reduction in unit production time (CIMA).

• Time taken to produce a unit of a product will decrease as an individual worker acquires specialization through repetitive learning.

• The average time per unit is shown in the image.

Steady State

• A state where no further improvements can be made because:
  • Machine efficiency restricts further improvement.
  • Workforce reaches their physical limits.
  • ‘Go-slow’ agreement among the employees.

Condition for Learning Curve Theory

• Significant manual element in the task.
• Repetitive task.
• Early stage production provide room for improvement.
• Consistency in the workforce.
• No extensive breaks in production.
• Motivated workers.

Uses of Learning Curve

• Provide better cost prediction, thus help in price setting.
• Helps in setting more realistic standards and more accurate budgeting.
• Aids in work scheduling.

Techniques of Budgeting

1) Rolling (continuous) budget

• Can be particularly useful when future events cannot be forecast reliably.
• It is a budget which is continuously updated by adding a further budget period when the earlier budget period is expired.
• Its prepared when there is an element of risk and uncertainty, and the future events cannot be forecasted reliably.
• Advantages:
  1. Budgets are more realistic and achievable since they are continuously revised to reflect changing circumstances.
  2. The annual disruption associated with the preparation of annual budget is removed.
  3. The pressure is stress placed on managers to achieve unrealistic budget targets are eased.
• Disadvantages:
  1. Preparing of rolling budget will take more time, effort and costly.
  2. There will be a greater workload on the managers and additional staff may be required.
  3. Managers may not devote sufficient time in preparing budgets.

2) Incremental budgeting

• The previous year’s budget will be taken as a base. When preparing the budget, the budget holder will add a certain percentage to allow for the changes in costs or revenue. There may also be other adjustments for specific items to be made in the current budget.
• Advantages:
  1. It is simple and cheap to prepare the budget.
  2. It is suitable in a stable situation where there is not much changes in the environment.
  3. It is also practical in predicting certain expenses such as telephone expenses, depreciation or rental.
• Disadvantages:
  1. It is assumed that the previous and current inefficiencies may be continuous and would carry on.
  2. It is not suitable for volatile and changing situations.
  3. The budget prepared for each activity may not be justified.

3) Zero–based budgeting (ZBB)

• Is a method to budget where all transaction and production elements are re-evaluated when budgets are about to be drawn up. The approach starts from zero as if there is no past record and that the budget is now prepared for the very first time. Therefore, budget preparers need to justify every expense there is in the budget proposed.
• ZBB promotes efficiency with operations where the managers are forced to revisit their activities regularly and review accordingly against budgets.
• Advantages:
  1. It helps to identify and remove any inefficiency or obsolete activity.
  2. Wasteful or over spending activities can be eliminated.
  3. It helps to create an environment where changes are easily accepted.
  4. ZBB focuses on the future rather than the past.
• Disadvantages:
  1. It is time consuming and costly to prepare zero-based budget.
  2. Managers sometimes tend to solve the short-term problems at the expense of long-term benefits.
  3. In preparing ZBB, it requires management skill which is sometimes lacking.

4) Activity-based budgeting (ABB)

• ABB is concerned with indirect expenses or overheads rather than direct expenses. Budgets for direct materials, direct labor and direct expenses can easily be prepared as it varies with production
• ABB refers to the budgeted statement of proposed activities for the future, by incorporating expected or budgeted costs and revenue. The orientation is based on ABC with emphasis on cost pools and cost driver rates for apportioning overheads to the activities and later to the products.
• Advantages:
  1. ABB is suitable when overheads are a significant amount.
  2. Activities are seen as the key to effective control
  3. Activity unit cost allows easier analysis of costs trends over time and intra- departmental comparisons.
• Disadvantages:
  1. The system is costly and needs skilled persons to prepare the budget.
  2. It will solely rely on the use of activity-based costing as the standard costing system.