Budgets

1. Budgets

2. What is a budget • A budget is a statement of planned future results which are expected to follow from actions taken by management to change the present circumstances • Example by introducing new products, or by increasing advertising, or by offering improved terms of trading • May be prepared for the business as a whole, for departments, for functions such as sales or production, for financial resources items such as cash, capital expenditure etc.

3. Purpose of budgets • Planning- forces managers to draw up plans of actions. • Planning helps clarify aims, consider and evaluate alternatives and chose best course available. Also helps foresee future problems • Coordination- Helps coordinate activities of all departments. • For instance, during budget setting process, an overall plan will be produced. Managers will then prepare their departmental budgets to fit in with overall plan

4. Purpose of budgets (Cont…) • Control- Budgets provide a useful means of financial control and of evaluating performance • Communication- Budgets are a means by which targets are communicated to and from managers and other employees. Departmental budgets show how the activity in each area of a business fits in with the overall plan • Motivation- Budgets can help motivate staffs if they are also involved in the budgetary process. They might get a sense of greater ownership

5. The preparation of budgets-planning • Planning is the establishment of objectives, and the formulation of the policies, strategies and tactics required to achieve them. • Planning comprises long term/strategic planning and short term operational planning

6. The value of long term planning • A budgetary planning and control system operating in isolation without any form of long term planning as a framework is unlikely to produce maximum potential benefits for an organisation • Therefore planning helps in:- • Identifying best course of action • Judging performance and hence analysis of firm’s potential • Taking the right decisions • With long-term planning, limiting factors which might arise can possibly be anticipated and avoided or overcome

7. The budget period and the budget manual • The budget period • Except for capital expenditure budgets, the budget period is commonly the accounting year (subdivided into 12 or 13 control periods) • The budget manual • The budget manual is a collection of instructions governing the responsibilities of persons and the procedures, forms and records relating to the preparation and use of budgetary data

10. Budget committee • The coordination and administration of budgets is usually the responsibility of a budget committee • The budget committee is assisted by a budget director who is usually an accountant • Every part of the organisation should be represented on the committee, so there should be representative from sales, production, marketing and so on

11. Functions of budget committee • Coordination of the preparation of budgets, which includes the issue of the budget manual • Issuing of timetables for the preparation of functional budgets • Allocation of responsibilities for the preparation of functional budgets • Provision of information to assist in the preparation of budgets

12. Functions of budget committee (Cont…) • Communication of final budgets to the appropriate managers • Comparison of actual results with budgets and the investigation of variances • Continuous assessment of the budgeting and planning process, in order to improve the planning and control function

13. Limiting (or principal budget factors) • Are circumstances which restrict the activities of a business. • Examples are • Limited demand for a product • Shortage of materials, which limits production • Shortage of labour, which also limits production • The availability of cash

14. Limiting (or principal budget factors) (Cont…) • They must be identified in order to decide the order in which the departmental budgets are prepared • If limiting factor is one of demand for a product, a sales budget will be prepared first • The other budgets will be prepared to fit in the sales budget • If it is the availability of materials or labour, then production budget will be prepared first an sales budget will be based on production budget

15. How to prepare a sales budget • Sales budget are based on the budgeted volume of sales. • The volume is then multiplied by the selling price per unit of production to produce the sales revenue

16. Example 1- Sales budget • Island style sales for the six months from January to June 2005 are budgeted in units as follows: • The current price per unit is Rs 15 but the company plans to increase the price by 15 % on 1 May

17. How to prepare a production budget • Manufacturing companies require production budgets to show the volume of production required monthly to meet the demand for sales. • Caution should be applied so that production is allocated to the correct months

18. Example 2- Production budget • Island style manufactures its goods one month before they are sold. • Monthly production is 105 % of the following month’s sales to provide goods for stock and for free samples to be given away to promote sales • Budgeted sales for July 2005 are 1,800 units • Prepare Island Style’s production budget for the period from December 2004 to June 2005

19. How to prepare a purchases budget • A purchases budget may be prepared for either • Raw materials purchased by a manufacturer, or • Goods purchased by a trader • A manufacturing company’s purchases budget is prepared from the production budget while a trader’s purchases budget is prepared from the sales budget. • It is calculated as follows:- Units produced per production budget * quantity of raw materials per unit produced * price per unit of materials

20. Example 3- Purchases budget • Island Style purchases its raw materials one month before production • Each unit of production requires 3 kg of materials which cost Rs 2 per Kg • Prepare the purchases budget for the materials to be used in the production of goods for the period from December 2004 to June 2005.

21. How to prepare an expenditure budget • An expenditure budget includes payments for purchased raw materials plus all other expenditure in the period covered by the budget • Caution should be applied so that purchased materials are paid in the correct month • In addition, all other expenses should be included in the budget in accordance with given information

22. Example 4- Expenditure budget • Island Style pays for its raw materials two months after the months of purchase. • Monthly wages of Rs 4,000 are paid in the month they are due • Staffs are paid a commission of 5 % on all monthly sales exceeding 15,000. The commission is paid in the month following that in which it is earned • General expenses are paid in the month they occur- January Rs 6,600, February Rs7,100, March Rs 6,900, April Rs 7,000, May Rs 7,300 and June Rs 7,500 • Island style pays interest of 8 % on a loan of Rs 20,000 in 4 equal installments on 31 March, 30 June, 30 September and 31 December • A final dividend of Rs 2,000 for the year ended 31 December 2004 is payable in March 2005

23. How to prepare a cash budget • Cash budgets are prepared from the sales and expenses budgets. Special care must be taken with respect to the following:- • Sales revenue must be allocated to the correct months • Receipt s from credit customers who are allowed cash discounts must be shown at the amounts after deduction of discounts. The discounts should not be shown separately as expense • Payments to suppliers (purchases) must be shown in the correct months

24. Example 5- Cash budget • Island Style’s sales in November 2004 were Rs 18,000 and in December 2004 were Rs 17,600 • Of total sales, 40 % are on a cash basis; 50 % are to credit customers who pay within one month and receive a cash discount of 2 %. The remaining 10 % pay within two months. • Rs 10,000 was received from the sale of a fixed asset in March 2005. The balance at bank on 31 December 2004 was Rs 12,400. • Prepare Island Style’s cash budget for the six months ending 30 June 2005.

25. How to prepare a master budget • A master budget is a budgeted profit and loss account and a balance sheet prepared from a sales, purchases, expenses and cash budget • Purpose is to reveal to management the profit or loss to be expected if management’s plans for the business are implemented and the state of the business at the end of the budget period

26. Activity 1 • Cash budget and master budget

27. Advantages Of Budgets • It brings about efficiency and improvement in the working of the organization. • It is a way of communicating the plans to various units of the organization. By establishing the divisional, departmental, sectional budgets, exact responsibilities are assigned. It thus minimizes the possibilities of buck passing if the budget figures are not met. • It is a way or motivating managers to achieve the goals set for the units. • It serves as a benchmark for controlling on-going operations.

28. Advantages Of Budgets (Cont…) • It helps in developing a team spirit where participation in budgeting is encouraged. • It helps in reducing wastage and losses by revealing them in time for corrective action. • It serves as a basis for evaluating the performance of managers. • It serves as a means of educating the managers.

29. Disadvantages of Budgets • In order to have proper budgets systems in place, the business must have a sound accounting system. • The budget targets must be concise and accurate, a budget which sets targets that are too easy will lead to de-motivation amongst staff, similarly, targets that set targets which are too high will simply result in de-motivation.

30. Guidelines For A Budget • Some simple pointers for a budget might include: • Establish clear objectives for the managers preparing the budget. • Set a timetable for the budget plan to be implemented. • Make sure the budgets are based on sensible targets, not too excessive/short. • Ensure departmental managers fully inform their teams of departmental budgets. • Ensure the monitoring process is clearly in place how often will the budgets be reviewed, monthly/quarterly/half-yearly?. • Make sure the review process is clearly established. • Review your annual budgets, re-appraise and review year-on-year.

31. Fixed and flexible budgets • Fixed budget remain unchanged regardless of the level of activity; • A fixed budget is a budget which is normally set prior to the start of an accounting period, and which is not changed in response to changes in activity or costs/revenues • Fixed budgets are also useful for controlling any fixed costs and particular non-productive fixed costs such as advertising, because such costs should be unaffected by changes in activity level (within a certain range) • Flexible budgets are designed to flex with the level of activity

32. Fixed budgets • The master budget prepared before the beginning of a budget period is known as the fixed budget. • However it does not mean that the budget will remain unchanged. • Revisions to the master budget will be made if the situation so demands

33. Fixed budgets (Cont…) • The term ‘fixed’ means the following:- • The budget is prepared on the basis of an estimated volume of production and an estimated volume of sales, but no plans are made for the event that actual volumes of production and sales may differ from budgeted volumes • When an actual volume of production and sales during the control period are achieved, a fixed budget is not adjusted to represent a new target for the new levels of activity • The major use of the fixed budget lies in its use in the planning stage , when it seeks to define the broad objectives of the organization

34. Flexed budget • Comparison of a fixed budget with the actual results for a different level of activity is of little use for budgetary control purposes • Flexible budgets should be used to show what costs and revenues should have been for the actual activity level. • Differences between the flexible budget figures and actual results are called variances • A flexible budget is a budget which is designed to change as volume of activity changes

35. Uses of flexible budget • At the planning stage • For example, suppose a company expects to sell 10,000 units of output during the next year. A master budget would be prepared on the basis of these expected volumes. However if the company thinks that output and sales are expected to be as low as 8,000 or as high as 12,000 units, it may prepare contingency flexible budgets, at volume of say 8,000, 9,000,11,000 and 12,000 units and assess the possible outcomes

36. Uses of flexible budget (Cont…) • Retrospectively. At the end of each control period, flexible budgets can be used to compare actual results achieved with what results should have been under the circumstances. Flexible budgets are an essential factor in budgetary control. • Management needs to know about how good or bad actual performances have been • For useful control information, it is necessary to compare actual results at the actual level of activity achieved against the results that should have been expected at this level of activity, which are shown by the flexible budget.

37. Example:Fixed and flexible budgets • X Ltd expects production and sales during the next year to be 90 % of the company’s output capacity, that is 9,000 units of a single product. Costs estimates will be made using the high-low method and the following historical records of cost:- • Units of output/sales Cost of sales 9,800 44,000 7,700 38,100 • The company’s management is not certain that the estimate of sales is correct, and has asked for flexible budgets to be prepared at output and sales levels of 8,000 and 10,000 units. The sales price per unit has been fixed at Rs 5. • Required:- Prepare appropriate budgets

38. Flexible budgets and budgetary control • Budgetary control is based around a system of budget centers • Each center has its own budget which is the responsibility of the budget holder • Therefore, individual managers are held responsible for investigating differences between budgeted and actual results, and are then expected to take corrective action or amend the plan in the light of actual events • It is vital therefore to ensure that valid comparisons are made.

39. Activity 2 • Flexible budgets and budgetary control

40. Activity 3 • Kim budgeted to sell 200 units and produced the following budget:- Sales 71,400 Variable costs:- Labour 31,600 Materials 12,600 ( 44,200) Contribution 27,200 Fixed costs 18,900 Profit 8300 • Actual sales turned out to be 230 units, which were sold for Rs 69,000. Actual expenditure on labour was Rs 27,000 and on materials Rs 24,000. Fixed costs totalled Rs 10,000. • Required: Prepare a flexible budget that will be useful for management control purposes.