PART 1 LESSON 1

FORECASTING TECHNIQUES

LESSON 1 BUDGETING CONCEPTS

CONTENT
1. Meaning
2. Purpose of Budgeting
3. Features of Successful budgeting process
4. Budget administration
5. Budget behavioral Consideration
6. Factors influencing budgeting process
7. Uses of cost standards
8. Management by Objectives
9. Time Frame for budgets
10. Sensitivity Analysis
11. Expected Value

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MEANING:
A budget is a quantitative expression of a proposed future plan of action. It
relates to a particular set of time period. It acts as a blueprint for the organization to
follow in the budget time period. Budgets quantify management’s targets regarding future
income, cash flows, financial position. Budgets are projected financial statements.
Budgets include a budgeted income statement, budgeted cash flow statement, and
budgeted balance sheet. Forecasts act as starting point of all the budgetary process.
Forecasts help in preparing revenue budgets. Budgets are also useful as guideposts.
Organizations actual performance is compared with budgets to determine whether
organization is lagging or exceeding expectations
Budget is a formal quantification of Management plans and has the following
features:

1. An organization has goals. Plans are formulated to reach the goals.

2. Plans specify the resources to be allocated and expected results
3. A Budget is a detailed written expression of an entity’s expectations with respect
to acquisition and use of resources for a specified period of time
4. A budget is a management tool. It is a quantitative statement of an
organizations plan of action for a specified period.
5. A budget is a quantitative expression, for a time period of a proposal of future
plan of action (Horngren).
6. Budget can cover both financial and non financial aspects of plans and acts as
blueprint for the organization to follow in the specified time period.
7. Budgets quantify management’s expectations regarding future income, cash
flows, and financial position.
8. Budgets prepare financial statements for future periods covering budgeted income
statement, a budgeted cash flow statement and a budgeted balance sheet.
9. Budgets are not only means of communicating management plans to the
organization but also provide a basis for evaluating segment and organization
performance by providing yardsticks against which actual performance could be
compared.

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Budgets touch every aspect of an organizations functioning. Budgets are prepared for all
the functions of the organization as illustrated below:

I
Std Costs/ABC/ IV
Performance
Flexible Budgets
Measurement/
/Forecasts Accounting
Management System
Cost Estimation
II III
Budgeting Responsibility
Accounting/Cost
Accumulation
Cash outflow
FINANCE
Cash inflow Capital Budget
Cash Budget
Budgeted Income Statement
Budgeted B/s/ cash Flow
INPUTS OUTPUTS
OPERATIONS
Production Budget Sales
Finished Goods DM Budget
DL Budget
MOH Budget

MARKETING
Sales Budget
Selling/distribution OH Budget

Planning Control
Management /Coordination

Purpose of Budgeting:
1. Forces Planning:
Budgets force managers to plan ahead for the activities of the
organization. The budgeting process compels managers at every level in the
organization, from chairman of the board to departmental supervisor to plan.

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Budget is most useful when done as part of organization’s strategic analysis. In a

strategic analysis management considers how an organization can best combine its
own capabilities with opportunities available in the market to accomplish overall
objectives.
Strategic planning considers questions like:
• What are the overall objectives of the organization?
• What are the markets for the products, market segments, trends in
the market, product differentiation, market niche etc? How is the
organization affected by the economy- different rates like: prices,
wages, interest, foreign exchange etc?
• Organizational forms and financial structures that suit the
accomplishment of strategy?
• Alternative strategies and risks associated therewith
2. Facilitate Communication and Coordination:
The budgeting process requires that managers of different
departments or divisions communicate about the plans they have made. In addition,
budgets provide GOAL CONGRUENCE and facilitate COORDINATION of
activities
Coordination is the meshing and balancing of all factors of production or services and
of all the departments and business functions so that the company can meet its
objectives. Communication is getting those objectives understood and accepted by all
departments and functions. Coordination and communication go hand in hand.
Budgets provide a means for communicating plans. Also through a master budget
each department knows the plans of other departments. Production manager knows
sales plan, purchasing manager knows of production plan, finance manager knows
about operations plan etc. This facilitates coordination
3. Allocate Resources:
Organizations have goals for market share, growth, dividend
payout etc. Non profit organizations may have social goals. Organizational plans

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allocate resources and specify expectations. A budget specifies the expectations in

specific terms.
4. Evaluate Performance and Provide Incentives:
Performance assessment: Budgets act as guideposts for assessing
success or failure of individual manages and functional areas. Actual revenues,
expenses, costs and other metrics are compared with budgets to determine whether
there is a lag or lead.
Budgeted performance measures are better than using past performance as a means
for judging actual results. Past performance may sometimes be below par or
substandard so may not be suitable for comparison of present performance. In
addition, performance expected in future may be different from what happened in
past because of changed circumstances and markets.
Budgets are prepared using standard costs and standard data. In addition, Budgets
take into account any expected changes because they are prepared within the
framework of organizations strategic plans. Budgets provide better measures for
performance assessment.
5. Provide Control:
Initially a budget is a planning tool, but it is also useful as a
controlling tool. Comparison of actual performance with budgets highlights
variances. Analyses of variances reveal measures to be taken for better utilization of
organizations resources.

Features of a successful budgeting process:

 Sufficient lead time: Must commence with fiscal year. It takes months of
preparation before a budget becomes final
 Budget planning calendar: Budgets are prepared for every function in the
organization. In addition, the budgets are interdependent. Therefore, the
completely budgeting process needs to be coordinated through a budget-planning
calendar that shows the schedule of activities to be carried on for development of

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the budgets. It specified when information is to be provided to others by each

information source
 Budget Manual: Prescribes detailed procedures for preparing the budget.
Prescribes standard forms to be used by departments to prepare budgets. Budget
manuals outline distribution instructions necessary to coordinate
interdependencies.
 Participation: Participative budgeting is necessary to ensure proper
implementation. The top management consisting of board of directors lay down
the mission. The senior management translates missions to strategic plans and
measurable, realizable goals. A Budget committee drafts budget manual and
budget calendar. Middle and lower management receive budget instructions, and
draw up the departmental budgets.

Budget Administration:
1) Employee resistance to budgeting program may be overcome with top
management support and proper administration of budget
2) An effective administrative framework should be established for successful
implementation and follow up of budgeting programs
3) Approaches to Budgeting may be Top Down where budgeting is done at the Top
and then disaggregated to units and sub-units. The disadvantage of this approach
is it may not evoke employee participation
a. In Bottom Up approach the budgeting is done at subunit/unit level and then
aggregated to an overall organization budget. At the subunit/unit level the goals of
the overall organization may not be understood which may result in lack of goal
congruence
b. Line managers should have the primary responsibility for development of
individual components of the budgets. But there is a need for technically
competent individual to provide assistance and to assume responsibility for
formalization of overall budget

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c. A Budget Director is appointed to administer the program and coordinate the

different phases of the program

Budget Behavioral Considerations:

1. Budgets are effective in some organizations and in not in some organizations,
because of the differences in the attitudes of lower level management and other
affected personnel toward budget
2. Budgets must be prepared to encourage employee behavior that promotes best
interests of the total organization
3. Budgets must be developed with active participation of all concerned
4. Managers must be discouraged from slacking or padding:
i) Sometimes managers may give highly conservative budgets in order to avoid
challenges.
ii) Padding the budget or introducing budgetary slack refers to the practice of
underestimating budgeted revenues in order to make budgeted targets easily
achievable.
iii) This happens often where managers are rewarded for performance.
iv) In addition, budgetary slack hedges marketing managers against adverse
circumstances.
v) There are also pressures on managers to overestimate the revenues while
preparing budgets. Overstated revenues results in challenge revenue budget.
Sometimes organizations use challenge budgets as motivational tools for
managers to work toward a challenge target which requires above average
effort
Factors Influencing budgeting process:
1. Organization’s strategy and internal environment
2. Industry situation: market share, governmental control, labor market, competitors
etc

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Use of Cost Standards:

1. Standard costs are predetermined expectations of how much a unit of input,
output or an activity should cost. The use of standard costs in budgeting allows
the standard-cost system to alert management when the actual costs of production
differ significantly from the standard.
2. Standard costs are based on accounting, engineering or statistical quality control
studies
Management by Objectives:
1. Management by objectives is often used in conjunction with a budgeting process
2. Under this approach, the organization’s mission or primary goal is broken down
into specific objectives.
3. Budgets are then developed to meet each of these objectives.
Time frame for Budgets:
1. The time frame for budgets differs according to the nature of the plan
2. Strategic plans and budgets involve longer time frames
3. Intermediate plans and budgets have time frame of up to 2 years
4. Operational plans and budgets have time frames of 1 month to 1 year

SENSITIVITY ANALYSIS
After a problem has been formulated into any mathematical model, it may be
subjected to sensitivity analysis. This approach is especially useful and significant when
probabilities have been derived subjectively rather than by using objectively quantifiable
information.
Sensitivity analysis is nothing more than reworking a problem using different
assumptions as to the facts.
This approach is especially useful and significant when probabilities of states of nature
and decision payoffs are derived subjectively rather than by using objectively
quantifiable information.
a. A trial-and-error method may be adopted in which the sensitivity of the solution
to changes in any given variable, parameter, or other assumption is calculated.

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1) The risk of the project being simulated may also be estimated.

2) The best project may be one that is least sensitive to changes in
probabilistic (Uncertain) inputs.
3) A sensitivity analysis may indicate whether expending additional
resources to obtain better forecasts of future conditions is cost justified.
b. In linear programming problems, sensitivity is the range within which a
constraint value, such as a cost coefficient or any other variable, may be changed
without changing the optimal solution. Shadow price is the synonym for sensitivity in
that context.

c. In the application of discounted cash flow methods (e.g., net present value), a
sensitivity analysis might be performed to ascertain the effects of variability of the
discount rate or periodic cash flows.

d. Financial planning models, including those for cash flows and

capital budgeting, are other significant applications of sensitivity analysis. For example,
changes in selling prices or resource costs may affect available cash and require more
or less short-term borrowing.

EXPECTED VALUE
For decisions involving risk, the concept of expected value provides a rational means for
selecting the best alternative. The expected value of an action is found by multiplying the
probability of each outcome by its payoff and summing the products. It represents the
long-term average payoff for repeated trials. The best alternative is the one having the
highest expected value.

EXAMPLE: An investor is considering the purchase of two different pieces of property.

The value of the property will change if a road, currently planned by the state, is built.
The following are estimates that road construction will occur:
Future State of Nature (SN) Probability

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SN 1: No road is ever built. 0.1

SN 2: A road is built this year. 0.2
SN 3: A road is built more than 1 year from now. 0.7

The following are estimates of the values of the properties under each of the three possible
future states of nature.
Property Value if SN 1 Value if SN 2 Value if SN 3
Property 1 $10,000 $40,000 $35,000
Property 2 $20,000 $50,000 $30,000
The expected value of each property is determined -by multiplying the probability of each
state of nature by the value under that state of nature and adding all of the products. Thus,
Property 1 is the better investment if the two properties cost the same.
P1: ($10,000 x .1) + ($40,000 x .2) + ($35,000 x .7) = $33,500
expected value P2: ($20,000 x .1) + ($50,000 x .2) +
($30,000 x .7) = $33,000 expected value
Some managers are reluctant to use subjectively derived numbers, arguing that they are
not measurable. Certainly, there is no way to prove the accuracy of the estimates. Their use,
however, makes explicit what would otherwise be decided subconsciously or intuitively.
Once stated, the reasonableness of subjectively derived numbers can be examined.
Another criticism of expected value is that it is based on repetitive trials, whereas many
business decisions involve only one trial.

EXAMPLE:
A company wishes to launch a communications satellite. The probability of launch failure
is .2, and the value of the satellite it the launch fails is $0. The probability of a successful
launch is .8, and the value of the satellite would then be $25,000,000.
The expected value is thus ($0 x .2) + ($25,000,000 x .8) = $20,000,000
However, $20,000,000 is not a possible value for a single satellite; it flies for
$25,000,000 or it crashes for $0.

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