CHAPTER EIGHT : BUDGETING
Definition of Budget:
A budget is a comprehensive and
coordinated plan, expressed in financial terms. It is a
predetermined detailed plan of action
developed and distributed as a guide to current operations.
Budgeting:
Budgeting is the process of preparing
and using budgets to achieve management objectives. It is the systematic
approach for accomplishing the planning, coordination, and control
responsibilities of management by optimally utilizing the given resources.
Difference Between Budgeting and Financial Planning:
1. Budgets are usually developed to match revenues against
planned expenditures and comply with the institution’s budget development and
reporting requirements. The purpose of strategic financial planning is to
project the long-term sources and uses of funds, evaluate the effectiveness of
programs and departments.
2. The budgeting process usually involves routine review of
annual expenditures. Financial planning, on the other hand, takes the
institution through an evaluation process that identifies areas in which
institution funds are being overspent or spent on ineffective programs.
3. The focus of a budget is on taking care of day-to-day
operating needs, such as staff, supplies, utilities, and benefits. Financial
planning focuses on allocating resources efficiently, making long-range plans
for new funds, and ensuring that funds are directed toward goals and priorities
of a strategic plan that is well thought out in advance, implemented and
followed.
4. The Managing Director, business heads and the people who
report directly to them are involved in financial planning, which plays a more
strategic role than traditional budgeting and places accountability on those
managing budgets and departments.
5. Most traditional budgets focus on the collection of
details , from head counts to supply use to salaries. Strategic financial
planning uses this information as a foundation and build on it.
6. Traditional budgets usually provide data for the budget
year and the previous year. Financial plans, in contrast, generally provide two
or more years of history and a three- to five-year projection of future
expenditures based upon strategic documents.
7. Traditional budgets ask, how is your department or
program going to spend its funds next year? Strategic financial plans ask, what
will you achieve with the level of funding requested for the next five years,
and how does that compare to other alternatives for the same goal or
service?
8. Budgets address the immediate operating needs of the
organization: how much money is spent on salary versus supplies, for example,
and how much is spent on each department. Strategic financial plans address
critical issues, such as when new funding will be needed.
9. Traditional budgets affect what happens during the coming
year, while strategic planning affects results for up to five years.
10. Traditional budgets show categorical spending only. Strategic financial plans show whether the
funds are being used effectively.
Objectives of Budgeting
The main objective of budgeting is to
assist the management in its main functions of planning, coordination and
control. In fact, budget is an important instrument of communication through
which management communicates its policies and targets to the persons doing
work.
METHODS OF BUDGETING
Zero Base Budgeting (ZBB):
It is a management technique aimed at cost reduction. It was
introduced by the U. S. Department of Agriculture in 1961. Peter A. Phyrr
popularized it. In 1979, president Jimmy Carte issued a mandate asking for the
use of ZBB by the Government.
ZBB – Definition : It is a planning and budgeting
process which requires each manager to justify his entire budget request in
detail from scratch (Zero Base) and shifts the burden of proof to each manager
to justify why he/she should spend money at all. The approach requires that all
activities be analyzed in decision packages, which are evaluated by systematic
analysis and ranked in the order of importance.
It implies that-
· Every budget starts with a zero base
· No previous figure is to be taken as
a base for adjustments
· Every activity is to be carefully
examined afresh
· Each budget allocation is to be
justified on the basis of anticipated circumstances
· Alternatives are to be given due
consideration
Incremental budgeting
This approach is to take the previous
year’s results and then to adjust them by an amount to cover inflation and any
other known changes. It is the most common approach, is a reasonably quick
approach, and for stable companies it tends to be fairly accurate. However, one large potential problem is
that it can encourage the continuation of previous problems and inefficiencies.
The reason for this is that the budget is a plan for the coming year – not simply
a financial forecast.
If we require a wages budget, we will
probably ask the wages department to produce it and they (using an incremental
approach) will assume that our workers will continue to operate as before.
They will therefore simply adjust by
any expected wage increases. As a result, the ‘plan’ for our workers stays the
same as before. Nobody has been encouraged to consider different ways of
operating that may be more efficient. It is at budget time that we perhaps
should be considering different ways of operating.
LIMITATIONS OF BUDGETING OR BUDGETARY CONTROL:-
Though budgetary control is an
important device of management control, it suffers from the following
limitations:
1) Budgets are based on Plan Estimates: budgets are based on estimates
made for planning. Naturally the success or failure of budget depends to a
large extent upon the accuracy of these estimates.
2) Budgeting is not a substitute of management: budget is not a
substitute of management; it is only a tool of management for achieving the
objectives of the concern. Hence, the success of budgeting depends on the
ability and efficiency of those persons who are responsible for budgetary
system.
3) Operation of the Budget plan is not automatic: mere preparation of
budget cannot ensure the advantages of budgeting. The execution of budget is as
important as its preparation.
However, its operation is not
automatic. In this context it is required that each executive
must feel his responsibility and
should make necessary efforts to attain the budgeted
goals.
4) Time effect: it takes some time in preparing budgets and during
this period many such changes may occur due to which it becomes difficult to
maintain the accuracy of budget.
5) Prohibitive cost: the installation of budgeting system involves too
much time and costs.
6) Effects of changing conditions: in rapidly changing conditions it
may not be possible to achieve the budgeted targets. Budgets may have to be
revised from time to time but
frequent revision of targets reduces the
importance of budget and involves additional
expenditure too.
7) Constraints on managerial initiative: budgetary control may serve
as constraints on
managerial initiative because every
executive tries to achieve the budgeted targets only.
There may be some efficient persons
who can exceed the targets but they will also feel
contended by reaching the targets.
8) Conflicts among functional executives: budgetary control may lead
to conflict among
functional executives because every
executive may try to secure a larger share of budgetary allocation, while the
success of budgetary control depends upon the team work.
CASH BUDGETS
The cash budget shows the effect of budgeted activities – selling,
buying, paying wages, investing in capital equipment and so on. It shows, in
summary form, the expected cash receipts and expected cash payments during the
budget period.
Liquidity and cash flow management are key factors in the successful
operation of any organization and it is with good reason that the cash budget
should receive close attention from both accountants and managers.
Cash Budget Preparation
Technique
Establish cash receipt from
debtors:
-
Forecast
the expected credit sales period by period, taking account of seasonal factors,
promotions, sales trends and so on.
-
Forecast
the typical payment pattern of debtors.
-
Based on
‘a’ and ‘b’, calculate when the budgeted sales revenue will be received as
cash, taking care to deduct any discounts allowed for prompt payment and making
an appropriate allowance for bad debts.
-
Take
care to allow for the cash receipts from the opening debtors.
Establish cash payments to
suppliers:
-
Based on
the production quantities budget, calculate the production quantities and
material usage quantities, period by period.
-
Based on
opening stock levels, the required closing stock level and the production
quantities from ‘a’ calculate the quantity and cost of material purchases,
period by period.
-
Decide
upon the length of credit period to be taken from suppliers and using ‘b’ calculate
when the cash payment will be made to suppliers,
-
Take
care to allow for cash payment to the opening creditors.
Establish payment for other
expense items – these include wages, salaries, bonuses, all types of overheads
and so on :
-
Forecast
of wages to be paid will, to some extend, depend on the production budget.
Allow for any bonus payments, cost of living increases, holiday pay, the delay
in selling PAYE and N.I payments and so on.
-
Salaries
can usually be forecast accurately but take care to allow for commissions,
bonuses, part-time assistance and so on.
-
The
amount and timing of many overhead items can often be forecast very accurately
eg, rates, telephones, electricity etc. Take care to exclude any non-cash items
which may be included in the general term ‘overheads’ eg, depreciation is a
notional cost, and not cash flow.
Payments and Receipts of major
non-trading items. Theses include:
-
Purchases
or sales of fixed assets. It is the amount and timing of the cash payment(s) or
receipt(s) that is of importance for cash budgeting not the way the item is
dealt with in the normal accounts. For example, the sale of a fixed asset for GMD5,000
which has a NBV of GMD8,000 will produce a notional loss in the normal accounts
of GMD3,000. In the cash budget it will,
of course, be shown as cash receipt of GMD5,000 in the appropriate period.
-
Tax
payments and dividends to be paid or received can usually be forecast
accurately.
-
Similarly
special transactions such as share issues, loan repayments and so on are
usually known well in advance.
Format of Cash Budgets
The typical cash budget has the general form shown below:
Cash
Budget
|
|
Period 1
|
Period 2
|
Period 3
|
|
Opening Cash Balance b/f
|
XXX
|
XXX
|
XXX
|
|
+ Receipts from Debtors
|
|
|
|
|
+ Sales of Capital Items
|
|
|
|
|
+ Any Loans Received
|
|
|
|
|
+ Proceeds for Share Issues
|
|
|
|
|
+ Any other Cash Receipts
|
|
|
|
|
= Total Cash Available
|
|
|
|
|
- Payments to Creditors
|
|
|
|
|
- Cash Purchases
|
|
|
|
|
- Wages and Salaries
|
|
|
|
|
- Loan Repayments
|
|
|
|
|
- Capital Expenditure
|
|
|
|
|
- Dividends
|
|
|
|
|
- Taxation
|
|
|
|
|
- Any other Cash Disbursements
|
|
|
|
|
= Closing Cash Balance c/f
|
XXX
|
XXX
|
XXX
|
Example :
The opening cash balance on 01st January was expected to be GMD30,000.
The sales budgeted were as follows:
|
November
|
GMD80,000
|
|
December
|
GMD90,000
|
|
January
|
GMD75,000
|
|
February
|
GMD75,000
|
|
March
|
GMD80,000
|
Analysis of records shows that debtors settle according to the
following pattern:
60% within the month of sales, 25% the month following , 15% the month
following.
Extracts from the purchases budget were as follows:
|
December
|
GMD60,000
|
|
January
|
GMD55,000
|
|
February
|
GMD45,000
|
|
March
|
GMD55,000
|
All purchases are on credit and past experience shows that 80% are
settled in the month of purchase and the
balance settled the month after.
Wages are GMD15,000 per month and overheads of GMD20,000 per month
(including GMD5,000 depreciation) are settled monthly.
Taxation of GMD8,000 has to be settled in February and the company will
receive settlement of an insurance claim
of GMD25,000 in March.
Prepare a cash budget for
January, February and March.
Answer :
Cash
Budget
|
|
January (GMD)
|
February (GMD)
|
March (GMD)
|
|
Opening Cash Balance b/f
|
30,000
|
24,000
|
17,250
|
|
Receipts from sales
|
79,500
|
77,250
|
78,000
|
|
Insurance Claim
|
0
|
0
|
25,000
|
|
= Total Cash Available
|
109,500
|
101,250
|
120,250
|
|
|
|
|
|
|
Payments :
|
|
|
|
|
Purchases
|
55,500
|
46,000
|
54,000
|
|
Wages
|
15,000
|
15,000
|
15,000
|
|
Overheads ( less dep’n)
|
15,000
|
15,000
|
15,000
|
|
Taxation
|
0
|
8,000
|
0
|
|
= Total Payments
|
85,500
|
84,000
|
84,000
|
|
= Closing Cash Balance c/f
|
24,000
|
17,250
|
36,250
|
Workings:
|
The receipts from sales are as follows:
|
|
|
|
January
Cash (GMD)
|
|
November (15% x 80,000)
|
12,000
|
|
December ( 25% x 90,000)
|
22,500
|
|
January (60% x 75,000)
|
45,000
|
|
|
79,500
|
|
|
|
|
|
February
Cash (GMD)
|
|
December (15% x 90,000)
|
13,500
|
|
January (25% x 75,000)
|
18,750
|
|
February (60% x 75,000)
|
45,000
|
|
|
77,250
|
|
|
|
|
|
March
Cash (GMD)
|
|
January (15% x 75,000)
|
11,250
|
|
February (25% x 75,000)
|
18,750
|
|
March (60% x 80,000)
|
48,000
|
|
|
78,000
|
|
|
|
|
Payments for Purchases:
|
|
|
|
January
Cash (GMD)
|
|
December (10% x 60,000)
|
6,000
|
|
January (90% x 55,000)
|
49,500
|
|
|
55,000
|
|
|
|
|
|
February
Cash (GMD)
|
|
January (10% x 55,000)
|
5,500
|
|
February (90% x 45,000)
|
40,500
|
|
|
46,000
|
|
|
|
|
|
March
Cash (GMD)
|
|
February (10% x 45,000)
|
4,500
|
|
March (90% x 55,000)
|
49,500
|
|
|
54,000
|
Reconciliation of Cash Balance
and Profits
The cash budget and profit and loss account are prepared on totally
different bases; the cash budget on the practical , objective basis of
measuring positive and negative cash
flows whereas budgeted profits are based on the normal conventions of
accounting. Thus, to reconcile the budgeted
cash and profit figures we can commence with one of the figures, say the
budgeted cash balance adjust as follows:
Add the following :
-
Credit sales : This is not included in the cash budget
but it is an element in the profit figure
-
Capital
expenditures : This was included in the cash budget but not debited to the
budgeted profit statement.
-
Taxation
-
Dividend
-
Disposal proceeds from the sale of fixed assets : This was
included in the cash budget whereas
in the budgeted profit statement only the gain or loss on the disposal of the
fixed assets should be included.
-
Decreased
in loan amounts
-
Expense
prepaid as at period end.
-
Gain on
disposal of fixed assets
Subtract the following:
-
Credit
purchases not included in the cash budget
-
Depreciation
-
Imputed
charges
-
Increased
in loans amount
-
Expenses
accrued at the period end
-
Loss on
disposal of fixed assets
Note: Changes in credit policies and stock levels
affect cash budgets but not profit statements. These should be
adjusted accordingly.
PRACTICE
QUESTIONS
1. a) Explain the stages of a budgetary control
system. [10]
b) Explain the benefits of an efficient
budgetary control system. [10]
2. a) Budgetary control is at the centre of the
financial management system of most organisations. Discuss. [10]
b) Explain the principal purpose of a cash
budget. [5]
c) Explain the term master budget. [5]
3. The
following is the actual and budgeted data for the period ending 31 December
2009:
Credit
sales:
May
and June 2009 GMD34,000
July,
August and September GMD39,000
October,
November and December GMD44,000
Credit
purchases
May
and June 2009 GMD17,000
July,
August and September GMD20,000
October,
November and December GMD22,000
Salaries
and wages payable each month GMD7,000
Insurance,
rent and rates payable each month GMD4,000
Other
overheads payable each month GMD6,000
Equipment
costing GMD60,000 is to be bought and paid for in July.
A
grant of GMD9,000 is expected to be received in July.
The
balance at the bank on 1 July 2009 is expected to be GMD4,000 OVERDRAWN.
Customers
are granted one month’s credit.
Suppliers
of goods for resale allow one month’s credit.
REQUIRED
a) Prepare the cash budget for the period July–December
2009. [12]
b) Comment on the budgeted cash flow position
revealed by your cash budget. [4]
c) Explain the term zero based budgeting. [4]
4. A company is about to bring a new product
to the market. The following budgeted data has been collected via the use of
various market research techniques:
GMD
Direct
material cost per unit 25
Direct
labour cost per unit 35
Variable
overhead cost per unit 40
Selling
price per unit 175
Fixed
overhead cost 1,100,000
Planned
production and sales 25,000 units.
Maximum
possible output 32,000 units.
REQUIRED
a) Calculate the original budgeted
profit. [3]
b) Calculate the original budgeted break
even point. [2]
c) It is thought that if an extra GMD125,000
was spent on marketing it would be possible to
sell 27,000 units
at the original budgeted selling price. Calculate the profit. [4]
d) It is thought that if the price was
increased to GMD200 per unit the company would sell
23,000 units. Calculate the profit. [4]
e) It is thought that by enhancing the
product, at a cost of GMD8 extra per unit spent on the
direct material and increasing the selling price to GMD210 per unit it would be
possible to sell 20,500 units.
Calculate the profit. [4]
5. The following is the first draft budgeted
data in respect of a new product which is being ‘brought to the market’ next
year:
Production/sales
(units) 50,000
Variable
costs per unit:
Direct
labour GMD30
Direct
material GMD40
Overheads GMD30
Suggested
selling price per unit GMD150
Fixed
costs to be absorbed by the product are estimated to be GMD1,100,000.
The
maximum possible production capacity is 60,000 units.
REQUIRED
a) Calculate the budgeted profit based on
the first draft budget.[3]
b) Calculate the budgeted break-even point,
based on the first draft budget. [2]
c) Calculate what the profit would be if the
selling price was increased to GMD160, and
46,000 units were made and sold. [4]
d) Calculate what the profit would be if the
selling price was decreased to GMD140, and
57,000 units were made and sold. [4]
e) Calculate what the profit would be if the
product was made to a higher quality and
design. This would increase the total
variable cost per unit by 10%. It is felt that the
selling price could be set at GMD160, and
that 45,000 units could be sold. [4]
f) Explain which of the above scenarios is
best for the business. [3]
6. The following is the actual and budgeted
data for the period ending 30 November 2009:
Credit
sales:
April
and May 2009 GMD36,000
June,
July and August GMD41,000
September,
October and November GMD45,000
Credit
purchases:
April
and May 2009 GMD19,000
June,
July and August GMD21,000
September,
October and November GMD25,000
Wages
payable each month GMD8,000
Rent,
business rates etc. GMD4,000
Other
overheads payable each month GMD6,000
Annual
insurance premium due in June GMD3,000
Equipment
costing GMD45,000 is to be bought and paid for in July.
An
EU grant of GMD8,000 is expected to be received in July.
The
balance at bank on 1 June 2009 is expected to be GMD1,000.
Customers
are granted one month’s credit.
Suppliers
of goods for resale allow one month’s credit.
REQUIRED
a) Prepare
the cash budget for the period June–November 2009. [12]
b) Comment
on the budgeted cash flow position revealed by your cash budget. [4]
c) Explain the benefits of preparing a cash
budget. [4]
7. The following is the actual and
budgeted data of a company for the first period ended 30 November 2009:
August September October November
GMD GMD GMD GMD
Sales 140,000 130,000 170,000 190,000
Purchases 60,000 90,000 95,000 90,000
Overheads 22,000 23,000 24,000 25,000
Wages 22,000 26,000 27,000 26,000
Other Information:
·
50% of
sales are on a cash basis and 50% are on a credit basis.
·
Debtors
are given one month’s credit.
·
Suppliers
give one month’s credit.
·
Overheads
are paid one month in arrears.
·
Overheads
include GMD2,000 in respect of the depreciation of fixed assets.
·
Wages
are paid in the month in which they are incurred.
·
New
machinery costing GMD60,000 will be paid for in October.
·
The
sale of old machinery will bring receipts of GMD7,000 in November.
·
The
bank balance is predicted to be GMD13,000 on 1 September 2009.
REQUIRED
a) Prepare
a cash budget for the three months ending on 30 November 2009. [10]
b) Comment
on the budgeted cash position of the company.
[4]
c) Outline
the PURPOSES of budgetary control. [6]
8. The following budgeted information is
provided for Notliman Ltd, for the six months ending 30 November 2009. The business assembles cardboard boxes.
|
Month
|
Sales
GMD
|
Materials
GMD
|
Wages
GMD
|
Other overheads
GMD
|
|
June
|
46,000
|
15,000
|
10,000
|
24,000
|
|
July
|
47,000
|
15,000
|
10,000
|
24,000
|
|
August
|
48,000
|
16,000
|
10,100
|
26,000
|
|
September
|
52,000
|
17,000
|
10,600
|
24,500
|
|
October
|
56,000
|
18,600
|
10,700
|
24,750
|
|
November
|
60,000
|
21,000
|
11,500
|
26,200
|
Additional information:
1.
It is
estimated that the bank balance at 01 September will be GMD1,350 overdrawn.
2.
10% of all
sales are expected to be cash sales.
3.
Customers who
settle their accounts within one month will receive a 5% discount. Settlement
after one month will be strictly net.
4.
It is believed
that half of all credit customers will settle their debts within one month and
that the remainder will pay the following month.
5.
All materials
will be paid for in the month following order, so that a cash discount of
2.5% can be claimed.
6.
Other
overheads will be paid for in the month following supply.
7.
The workforce
was granted a 5% pay increase which will come into force on 01 November 2009.
The pay rise has not been included in the budgeted figures. Wages are paid in
the month following that in whch they are earned.
8.
The
half-yearly interest on 400,000 6%
debenture of GMD1 each is due to be paid on 15 October 2009.
9.
1,000,000
ordinary shares of GMD0.10 were issued in July 2008 at a price of GMD0.24 each.
The final call of 25% is due on 01 November 2009.
10. A new folding machine costing GMD20,000 will be delivered on 01 September.
It will be paid for in two equal instalments on 01 December 2009 and 01 June
2010. It is expected that the machine will be used continuously for the next
four years.
11. It is estimated that stock at 01 September
2009 will have a value of GMD4,700 and will rise by GMD1,000 at 30 November
2009.
REQUIRED:
(a) Prepare a cash budget for each of the three months ending 30 September, 31 October and 30 November
2009. (20)
(b) Prepare a forecast trading and profit
and loss account for the three-months ending 30 November 2009. (14)
(c ) Explain two difference between a cash budget and a cash flow
statement. (4)
(d) Explain one measure that the managers of a business might adopt if they are faced with a cash
deficit in one month of an annual cash budget. (2)
9. Wanita
is to open a retail clothes store on 1 January 2010. She will put in GMD140,000
in the bank as capital. Her plans are as follows:
·
On 1
January to buy and pay for premises GMD75,000, equipment GMD14,000 and a
vehicle GMD11,000.
·
To
employ staff and pay them GMD2,600 per month (ignore tax and NI) – such wages
are to be paid on the last day of each month.
·
To buy
the following quantity of garments:
Jan. – March inclusive 600
April – June inclusive 700
·
To sell
the following quantity of garments:
Jan. – March inclusive 500
April – June inclusive 750
·
The
average cost per garment will be GMD12 and the suppliers will be paid in the
same month.
·
The
average selling price per garment will be GMD36. 75% of the sales will be on a
cash basis. The other 25% will be on one month’s credit.
·
Wanita
will draw GMD1,600 per month as drawings.
·
Wanita
expects to spend GMD1,400 per month on advertising. This is to be paid in the
same month.
·
Other
expenses are estimated to be GMD2,600 per month, payable in the month
following.
·
Wanita
plans to depreciate the equipment at the rate of 20% p.a., and the vehicle at
the rate of 25% p.a.
REQUIRED
a) Prepare a cash-flow budget for the period 1
January 2009 to 30 June 2009. [10]
b) Comment on the budgeted cash-flow position
of Wanita. [5]
c) Explain the term flexible budget. [5]
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