Managing Financial Principles and

Techniques

Topic 3
Budgetary Process of an
Organisation

Fathimath Rasheed
MBA Batch 11
 Introduction
A budget is a detailed plan, which shows the financial
consequences of an organisation’s operating activities for a
specific future time period.
A budget acts as a financial model that summarises future
operations and it is usually viewed as a core component of an
organisation’s planning and control system.
Strategic planning is the term given to the long-term planning,
usually undertaken by senior managers. It involves making
decisions about the types of businesses and markets that an
organisation operates in, and about how those businesses and
activities will be financed.
Purpose of Budgeting
The procedures and activities that are undertaken to develop the
budget are called the budgeting process.
The budgetary process can serve five primary purposes;
1. Planning; most obvious purpose of a budget is to quantify a plan of
action.
2. Facilitating communication and co-ordination; for a business to plan
operations effectively there must be good communication and co-
ordination between all managers. The budgeting process provides a
formal mechanism to enable this to take place.
3. Allocating resources; Generally a firm’s resources are limited and
budgets provide one way of allocating resources among competing
uses.
4. Controlling profit and operations; the budget can serve as a
benchmark to allow a comparison against actual financial results at all
level of a business.
5. Evaluating performance and providing incentives; Comparing actual
results with budgeted results also helps managers evaluate
performance of individuals, departments, divisions or the entire
company.
Responsibility accounting
Responsibility accounting is the term that describes the practice of
holding managers responsible for the activities and performance of
their area of business.
As part of the budgeting process, the managers of various departments
or other sections of a business are often required to develop their own
budget estimates for the cost, revenue of profits of their areas.
These same managers are then held responsible for meeting budget
targets when actual operations commence.
The annual budget
The annual budget (sometimes called the master budget) is a
comprehensive set of budgets that covers all aspects of a firm’s
activities. The annual budget consists of many separate independent
budgets.
The sales budget and the various cost budgets are often termed the
operating budgets.
The financial budgets consist of the budgeted statement of financial
performance, the budgeted statement of financial position, the cash
budgets and the capital expenditure budget.
The sales budget
Most budgeting processes begin with the sales budget, which is a
detailed summary of the estimated sales units and revenue from the
organisation’s products for the budget year based of the sales forecast.
Sales forecasting involves estimating which products will be sold, in
what quantities.
Major factors that are considered when forecasting sales will differ,
depending on the industry and the nature of the firm, but will include
the following;
1. Internal factors
* Past sales levels and trends for the company.
* New products planned by the company
* The intended pricing policy of the company
* Planned advertising and product promotion
2. External factors
- General economic trends.
- Economic trends that directly relate to the company’s industry.
- Other factors expected to affect sales in the industry.
- Political and legal events.
- Expected activities or competitors and customers.
The cost budgets
Following the sales budget, a firm develops a series of cost budgets that
detail the cost of operations that will be carried out to support the
forecast demand for its goods and services.
A manufacturing firm develops a production budget, which shows the
number of units of products to be manufactured.
They will also make budgets for direct materials, direct labour and
manufacturing overheads.
Behavioural consequences of
budgeting
A budget affects virtually everyone in an organisation; those who
prepare the budget, those who use the budget to facilitate decision
making, and those whose performance is evaluated using the budget.
Participative budgeting
Participative budgeting allows managers at all levels to develop their
own initial estimates for budgeted sales, costs and so on.
Top-down budgeting describes the system where senior managers
impose budget targets on more junior managers, there is little
participation or consultation in the budget-setting process.
Bottom-up budgeting is used to describe the participative process
where people at lower managerial and operational levels play an active
role in setting their own budgets.
Budgetary Slack: Padding the budget;
In a participatory budgeting system, the information upon which a
budget is based comes largely from people throughout the business.
When a supervisor provides a departmental cost estimates, there is an
incentive to overestimate costs.
When the actual cost incurred in the department is found to be less
than the inflated cost projection, the manager may believe that the
supervisor has managed the department in a cost effective way.
Budget padding means underestimating the revenue or overestimating
the costs. The difference between the estimate provided and a realistic
estimate is called the budgetary slack.
Reasons;
- belief that their performance would look better if they can ‘beat the
budget’
- to cope with uncertainty.
- since managers are coping with limited resources, it is common for
initial budget requests to be cut by superiors or budget review
committee.
To solve;
- Avoid relying on the budget as a negative evaluative tool.
- Give incentives not just to achieve the budget but also to provide
accurate projections.
3- Budget difficulty
Budgets to be motivational, employees must accept the budgets as their own.
The situation where the organisation’s goals coincide with an individuals goals is
called goal congruence. Achieving this one of the greatest challenges of managing an
organisation.
Budget acceptance is more likely when:
- Targets are developed with the participation of employees.
- Targets are considered achievable.
- There is frequently feedback on performance.
- Employees are held responsible for activities that they believe are within their
control
- Achievement of targets is accompanied by rewards that are valued.
Zero based budgeting
Zero based budgeting is a process where all activities in the organisation
are initially set to zero.
To receive an allocation of resources during the budgeting process,
managers must justify each activity in terms of its continues usefulness
to the business.
Forces managers to rethink each phase of the firm’s operations before
requesting for resources.
Criticized for being too introspective since managers focus on their part
of business and overlook the other departments.
Trade receivables budget
This would normally show the planned amount owed to the business by
credit customers at the beginning and at the end of each month, the
planned total credit sales revenue for each month and the planned total
cash receipts from credit customers (trade receivables).
The layout would be something like the following:
Trade payables budget
Typically this shows the planned amount owed to suppliers by the
business at the beginning and at the end of each month, the planned
credit purchases for each month and the planned total cash payments
to trade payables.
The layout would be something like the following:
Inventories budget
This would normally show the planned amount of inventories to be held
by the business at the beginning and at the end of each month, the
planned total inventories purchases for each month and the planned
total monthly inventories usage.
The layout would be something like the following:
Raw materials inventories budget, for a manufacturing business, would
follow a similar pattern, with the ‘inventories usage’ being the cost of
the inventories put into production.
A finished inventories budget for a manufacturer would also be similar
to the above, except that ‘inventories manufactured’ would replace
‘purchases’.
A manufacturing business would normally prepare both a raw materials
inventories budget and a finished inventories budget.
There are two components to corporate financial planning: planning for
cash flows and planning for profits.
The first step is cash budget planning (remember cash is king).
A good cash budget becomes the foundation for a profit plan. The
second step is planning for profits.
The profit plan involves pro forma statements. A pro forma statement is
projected figures for a company to use in the financial planning process.
A cash budget is simply a listing of the firm’s anticipated cash
inflows and outflows over a specified period it includes only
actual cash flows. It is also called “Statement of budgeted cash
receipts and disbursements”.
A cash budget is prepared to:
Monitor the timing of cash in and cash out
Make sure there is enough cash available
See if and when a bank overdraft is required
Plan the timing of the purchase of a Fixed Asset
Avoid a negative cash flow situation
Cash Inflows and Outflows
Any cash coming in to the company is a cash inflow; for the sake
of consistency and to avoid errors, we will always use positive
numbers to represent inflows.
Any cash leaving the company is a cash outflow, and will be
represented by a negative number.
Simply put, inflows are sources of cash while outflows are uses of
cash.
When a company pays its advertising bill, it is a cash outflow.
When the company receives payment from a customer, it is a
cash inflow.
Cash increases occur anytime you have a decrease in any asset or
an increase in liabilities.
If any of your assets decrease (for example accounts receivable or
inventory) this means that cash has been freed up to be held as
cash instead of being tied up as AR or in inventory.
Conversely, a company’s cash balance decreases (cash outflow) if
there is an increase in any of its assets.
If accounts receivable or inventory increases, then that is more
money held as that asset and therefore less money held as cash.
So the company’s cash balance decreases.
With liabilities the opposite is true. An increase in any liability
such as accounts payable results in an inflow of cash.
In other words, if accounts payable increases than that means we
did not pay as much on our payables and therefore we are
holding more cash.
If accounts payable decreases, then we have a cash outflow
because we used cash to pay our payables.
Profit is a bit easier. Any profit is a cash inflow and any loss is a
cash outflow.
Cash Inflows
Sales and other cash income
New loans received
Sales of capital assets
Cash Outflows
Cash expenses
Principal payments
Purchase of capital assets
Do not include:
Depreciation
Opportunity costs
Any other noncash income or expense
CALCULATING THE ENDING CASH BALANCE
Beginning Cash Balance
+ Total Collections
– Total Disbursements/ outflows
= Unadjusted Cash Balance
+ Current Borrowing
= Ending Cash Balance
General format of cash budget
The key input to the short-run financial planning process, and
therefore any cash budget, is the firm’s sales forecast.
This is a prediction of the firm’s sales over a given period and is
ordinarily provided to the financial manager by the marketing
department.
An external forecast is based on the relationship between the
firm’s sales and certain key external economic indicators, such
GDP, new housing starts and disposable personal income.
Internal forecasts are based on a build-up, or consensus, of sales
forecasts through the firm’s own sales channels.
Firms generally use a combination of external and internal
forecast data the final sales forecast.
Cash receipts
Includes all items form which cash inflows result in any given financial
period.
The most common components of cash receipts are cash sales,
collections of accounts receivable and other cash receipts.
Eg. Coulson Industries is developing a cash budget for Oct, Nov and
Dec. Coulson’s sales in Aug and Sep were $100,000 and $200,000
respectively. Sales of $400,000, $300,000 and $200,000 have been
forecast for Oct, Nov and Dec respectively. Historically, 20% of the
firm’s sales have been for cash, 50% have generated accounts
receivables collected after one month, and the remaining 30% have
generated accounts receivables collected after two months. In Dec,
the firm will receive $30,000 dividend from shares in a subsidiary.
Forecast Sales; The initial entry is merely informational. It is
provided as an aid in calculating other sales-related items.
Cash sales; The cash sales shown for each month represent 20%
of the total sales forecast during that month.
Collections of A/R; These entries represent the collection of
accounts receivable (A/R) resulting fro, sales in earlier months.
Lagged on month; These figures represent sales made in the
preceding month that generated A/R collected in the current
month. Since 50% the current month’s sales are collected one
month later. The collection of A/R with one-month lag shown for
Sep, Octo, Nov and Dec, representing 50% of sales in Aug, Sep,
Oct and Dec respectively.
Lagged two months; These figures represent sales made two months
earlier that generated A/R collected in the current month. Since 30% of
sales are collected two months, later the collections with a two-month lag
shown for Oct, Nov and Dec represents 30% of the sales in Aug, Sep and
Oct, respectively.
Other cash receipts; These are cash receipts expected to result from
sources other than sales. Items such as interest received, dividends
received, proceeds from sale of equipment, share and bond sale proceeds
and lease receipts may show up here. For Coulson Industries, the only
other cash receipts is the $30,000 dividend due in December.
Total cash receipts; This figure represents the total of all cash receipt items
listed for each month in the cash receipt schedule. In the case of Coulson
Industries, we are concerned only with Oct, Nov and Dec.
Cash disbursements include all outlays of cash in the period
covered. The most common disbursements are;
Cash purchases Non-current-asset outlays
Payments of accounts payable interest payments
Payment of cash dividends Wages and salaries
rent (and lease) payments principal payments (loan)
Repurchases or retirement of shares
Tax payments
Coulson Ind has gathered the following data needed for the
preparation of a cash disbursements schedule for the months of
Oct, Nov and Dec
Purchases; The firm’s purchases represent 70% of sales. 10% of
this amount is paid in cash. 70% is paid in a month immediately
following the month of purchase and the remaining 20% is paid 2
months following the month of purchase.
Cash dividends; cash dividends of $20,000 will be paid in Oct.
Rent payments; Rent of $5000 will be paid each month.
Wages and salaries; The firm’s wages and salaries can be
estimated by adding 10% of its monthly sales to the $8000 fixed
cost figure.
Taxes of $25,000 must be paid in December.
Non-current asset outlays; New machinery costing $130,000 will
be purchased and paid for in Nov.
Interest payments; An interest payment of $10,000 is due in Dec.
The company had $ 50,000/- at the start of the year and require
to maintain $25,000/- each month as the minimum cash balance.
A firm’s net cash flow is found by subtracting the cash
disbursements from cash receipts in each period.
By adding the beginning cash to firm’s net cash flow, the ending
cash for each period can be found.
Subtracting the minimum cash balance from the ending cash
yields the required total financing or the excess cash balance.
If the ending cash is less than the minimum cash balance,
financing is required.
Coping with uncertainty in the
cash budget
There are two ways of coping with uncertainty of cash budgets.
First way is to prepare several cash budgets, one based on
pessimistic forecast, one based on the most likely forecast and
third based in an optimistic forecast.
Reveal the funding required to cover the most adverse situation.
Second is using several cash budgets each based on different
assumptions.
Budgeting for control
Types of control
The control process just outlined is known as feedback control.
Its main feature is that steps are taken to get operations back on track
as soon as there is a signal that they have gone wrong.
There is an alternative type of control, known as feed-forward control.
Here predictions are made as to what can go wrong and steps taken to
avoid any undesirable outcome.
Flexing the budget
Flexing the budget simply means revising it, assuming a different
volume of output.
To exercise control, the budget is usually flexed to reflect the volume
that actually occurred, where this is higher or lower than that originally
planned.
This means that we need to know which revenues and costs are fixed
and which are variable relative to the volume of output
Flexible budgets allow us to make a more valid comparison between
the budget (using the flexed figures) and the actual results.
Key differences, or variances, between budgeted and actual results for
each aspect of the business’s activities can then be calculated.
Sales volume variance
losing sales volume generally means losing profit.
When we consider the relationship between cost, volume and profit
selling one unit less will result in one less contribution to profit.
The difference between the original and flexed budget profit figures is
called the sales volume variance.
Adverse variance, taken alone, has the effect of making the actual
profit lower than the budgeted profit.
A variance that has the effect of increasing profit beyond the budgeted
profit is known as a favourable variance.
We can therefore say that a variance is the effect of that factor (taken
alone) on the budgeted profit.
Sales price variance
Price difference in actual versus the budget is known as the sales price
variance.
Higher sales prices will, all other things being equal, mean more profit.
Materials variances
Variance of materials used in the production is known as the direct
materials usage variance.
Normally, this variance would be the responsibility of the production
manager.
If higher-than-budgeted cost per unit of raw materials is paid, it is the
responsibility of the buying manager
Labour variances
Direct labour variances are similar in form to those for direct materials.
The total direct labour variance is the difference on labour than was
budgeted for the actual level of output achieved.
The direct labour efficiency variance compares the number of hours
that would be allowed for the achieved level of production with the
actual number of hours used.
The direct labour rate variance compares the actual cost of the hours
worked with the allowed cost
Fixed overhead variance
The fixed overhead spending variance is simply the difference between the
flexed (or original – they will be the same) budget and the actual figures.
In practice, overheads tend to be a very slippery area, and one that is
notoriously difficult to control.
Fixed overheads (and variable ones) are usually made up of more than one
type of cost.
Typically, they would include such things as rent, administrative costs,
salaries of managerial staff, cleaning, electricity and so on.
These could be individually budgeted and the actuals recorded. This would
enable individual spending variances to be identified for each element of
overheads, which in turn would enable managers to identify any problem
areas.
Sales Volume Variance = Flexed budget profit – original budget profit
Sales Price Variance = Actual Sales – Flexed budget sales
Direct Material Usage = (Flexed budget usage – Actual usage) x Price
Direct Material Price = (Actual Usage x Price) – Actual Amount Paid
Direct Labour Efficiency = (Flexed budget hours – Actual hours) x Rate
Direct Labour Rate = (Actual budget hours x Rate) – Actual amount paid
Fixed Overhead spending = Budget amount – Actual Amount
Reasons for adverse variances
Sales volume
- Poor performance by sales staff.
- Deterioration in market conditions between the time that the budget
was set and the actual event.
- Lack of goods or services to sell as a result of some production
problem.
Sales price
- Poor performance by sales staff.
- Deterioration in market conditions between the time of setting the
budget and the actual event.
Direct materials usage
- Poor performance by production department staff, leading to high
rates of scrap.
- Substandard materials, leading to high rates of scrap.
- Faulty machinery, causing high rates of scrap.
Direct materials price
- Poor performance by the buying department staff.
- Using higher quality material than was planned.
- Change in market conditions between the time that the budget was
set and the actual event.
Labour efficiency
- Poor supervision.
- A worker with a low skill grade taking longer to do the work than was
envisaged for the correct skill grade.
- Low-grade materials, leading to high levels of scrap and wasted labour
time.
- Problems with a customer for whom a service is being rendered.
- Problems with machinery, leading to labour time being wasted.
- Dislocation of materials supply, leading to workers being unable to
proceed with production.
Labour rate
- Poor performance by the human resources department.
- Using a higher grade of worker than was planned.
- Change in labour market conditions between the time of setting the
budget and the actual event.
Fixed overheads
- Poor supervision of overheads.
- General increase in costs of overheads not taken into account in the
budget.
Question and Answer Session

Q &A