Budgets help managers run the business. They provide means for assessment whether actual performance was as planned and, if not, what are the reasons for it. Budgets are an integral part of planning framework adopted by well-run businesses.
How budgets link with strategic plans?
Businesses need to develop plans for the future. The development of plans involves five key steps:
Establish mission and objectives. A mission statement is developed that intends to capture the essence of the business. The strategic objectives will be set to achieve the mission in a form of quantified goals.
Undertake a position analysis. This includes the assessment of where the business currently is from where it wants to be as set in the mission and strategic objectives.
Identify and assess the strategic options. Business explores the various ways in which in might move from where it is now and where it wants to be.
Select strategic options and formulate plans. This involves selecting the best point of action and formulating long-term strategic plan. The long term plan is generally broken down into a number of short-term plans. These plans are the budgets - a short-term plan typically for one year expressed in financial terms. Budgets will define the targets. For example:
* cash receipts and payments;
* sales volumes and revenues;
* detailed inventories requirements;
* detailed labour requirements;
* specific production requirements.
5. Perform, review and control. Here we pursue the budgets. We compare the actual outcome with the budget we can see whether these are going in accordance with a plan. Actions need to be taken if actual performance does not match the plan.
We can summarise that the mission sets the overall direction and likely to last for a very long time. The long-term strategic objectives set out in the mission are planned to be achieved. The strategic plans will determine how the objectives will be pursued. The budgets set out the short-term plans and targets necessary to fulfil the strategic objectives.
The planning and control process is presented in the figure below.
Source: Peter Atrill , and Eddie McLaney, 2017, "Accounting and finance for non-specialists"
Planning should be the responsibility of managers. Accountants supply relevant information to the managers and contribute to the decision making and accountants should not dominate the process. If managers allow this to happen, managers will fail in their responsibilities. Accountants should not have excessive influence on the budgeting process.
Time of plans and budgets
Setting strategic plan is generally conducted every 5 years or so. Budgets are generally set for the forthcoming year. The time horizons may depend on the organisational context. An annual budget sets targets for the forthcoming year for all aspects of the business. Usually it is broken down into monthly budgets, which define the monthly targets. The annual target will be built from monthly figures. Sales staff may be required to set sales targets for each month of the budget period. They may vary from month to month, perhaps due to variations of seasonal demands.
How budgets help managers?
Budgets have many area of usefulness. The main ones are presented below:
Promote forward thinking and identification of short-term problems
Focusing on the future enables managers to spot potential problems in an early stage and take steps to avoid issues and deal with the problems. It gives managers time for calm and rational considerations, chose the best solution for the issues and take action well in advance.
Help coordination between the various sections of the business
It is important that the activities of the various departments are linked the way so that activities of one function compliment another. For example, the activities of the purchasing department should compliment the production and stores.
Motivate managers for better performance
Having a stated task can motivate manager and staff in their performance. Telling managers to do their best is not very motivating, but they will be more motivated when their actions are linked to the overall business objectives. Budgeting makes it possible to achieve these strategic operational objectives.
Provide basis for system of control
If managers wish to control and monitor their own performance, they need something to measure against. Current performance can be compared with past performance. Current performance can be compared with planned performance (budgets). Managers can take steps to achieve these targets.
Comparing the budget with actual outcomes enables the use of the "management by exception". This is where senior management spent most of their time dealing with activities that fail to achieve the budgets. It allows them to exercise self-control. By knowing what is expected of them, they know how well they perform and take steps to correct matters.
Provide system of authorisation to spend up to a particular limit
Some activities (such as research and development) are allocated at fixed amount at the discretion of senior management. This provides the authority to spend.
The five identified uses of budgets can conflict with each other on occasion. Sometimes budgets are set higher then managers can achieve them to motivate them. Managers must decide which use of the budget should be given a priority and be prepared to trade off the benefits.
Budgets and forecasts
Budget is a short-term goal generally expressed in financial terms. Budget is a plan, and not a forecast. Clearly, forecasts are helpful to the budget setter. But forecast and budget are distinctively different.
Limiting factors
Some aspects of a business, will stop it achieving its objectives to the maximum extend. Production shortage (labour, materials, or plant) maybe a limiting factor. Production shortages may be overcome by increasing the funds. But this is not always a practical solution because the money will but labour skill and increase the supply of raw materials. It might be necessary to revise the sales budget to a lower level to match the limits in production. We should try to identify the limiting factors at the outset and taken into account when preparing for the budgets.
How budgets link to one another?
Large businesses will prepare more then one budget for a particular period. Each budget will relate to a specific aspect of the business. Ideally, there should be separate operating budget for each person who is in managerial position. The contents of the individual budgets will be presented in "master budget" consisting of the income statement and the statement of financial position.
Figure below presents interrelationships of individual operational budgets for an example of manufacturing company.
Source: Peter Atrill , and Eddie McLaney, 2017, "Accounting and finance for non-specialists"
The Sales budget is generally the first one to be prepared, because the level of sales determines the level of activity. Sales budget is the most common limiting factor. The finished inventories requirements are set by the levels of sales. The finished inventories will define the production levels and individual production departments. The demands of manufacturing define the raw materials inventories budgets.
The purchases budget will dictate the materials inventories budget which will dictate the trade payables budget. Cash will also be affected by overheads and direct labour costs and by capital expenditure.
The way in which budgets link to one another results in coordination of budgets.
There is also a vertical relationship between budgets. Breaking down the sales budget into a number of subsidiary budgets, perhaps for each regional manager, is a common approach. The overall sales budget will be the result of the subsidiary ones ( see figure below).
Source: Peter Atrill , and Eddie McLaney, 2017, "Accounting and finance for non-specialists"
In the example above, the business has four geographical sales regions which is a responsibility of relevant sales manager.
Although sales are often managed on geographical basis, they may be managed by some other basis, for example a particular type of product. Large businesses may have separate product-type managers for each geographical regions.
All of those budgets must mesh with the master budget, that is the budgeted income statement and statement of financial position.
Budgets in practice
Some very successful organisations have a comprehensive planning and financial reporting procedures including annual budgets and periodic strategic plans, both which are reviewed and approved by the board. There is also an ongoing monitoring of performance against budgets through periodic reporting and detailed accounts management and the key performance indicators (KPIs).
Many organisations, particularly large ones prepare and use budgets. Many companies have formal budgeting process.
Preparing budgets
The cash budget
We start with the cash budget because it is the key budget. Most economic aspects of a business are reflected in cash sooner or later. A small business may feel that full-scale budgeting is not needed for their business, but it should prepare a cash budget as a minimum.
The layout of the budgets will vary from one business to another. Managers use budgets for similar purposes. The cash budget will normally consist of the following characteristics:
Budget period is broken down into sub-periods;
The budget is in columnar form with one column for each month;
Receipts of cash would be identified under different headings and the total of each months receipts shown;
Payments of cash would be identified under various headings and the total of each months payments shown;
The surplus of cash receipts over payments, or of payments over receipts would be identified;
The running end-of-month cash balance would be identified. Achieved by taking the balance of the previous month and adjusting it for the surplus ( or deficit) of receipts over payments for the current month.
An example of budgeted income statement is presented in figure below:
Source: Peter Atrill , and Eddie McLaney, 2017, "Accounting and finance for non-specialists"
The business in the example allows to its customer's one month credit. The business plans to maintain its inventories at the existing level, until in March there are to be reduced by £5,000. Inventories purchases are made on 1 month credit. December purchases totalled £30,000. Salaries and wages are paid in the month concerned. Electricity is paid quarterly around March and June. The business plans to pay for new delivery van in March for the cost of £15,000 and existing van will be traded for £4,000. It expects to have £12,000 in cash at the beginning of January. The budget plan would look like below:
Source: Peter Atrill , and Eddie McLaney, 2017, "Accounting and finance for non-specialists"
We can see that the cash receipts from credit customers (trade receivables) lag a month behind sales because customer are given a month to pay for their purchases. December sales will be paid in January.
We also know that in the majority of the months the purchases of inventory will equal the costs of goods sold. They will replace the amount used with new inventories, but in March they plan to reduce by £5,000.
Each months cash balance would be the previous end-of-month figure plus the cash surplus ( or minus the cash deficit) for the current month. The balance for January is £12,000 as stated.
Depreciation does not give raise to cash payment.
we can see that there is a large cash balance and seem to be increasing. the company could put some of the cash into income-yielding deposit, increasing the investment of non-current (fixed) assets, paying the dividend to the owners, repaying borrowings.
Preparing other budgets
Each budget will have its own particular features, but other budgets will follow similar format to the cash budget. That is where we show inflows and outflows during each month and opening and closing balances of each month.
Trade receivables budget
This would normally show the planned amount owned to the business by credit customers at the beginning and the end of each month. It would also show the planned total credits sales revenue for each month and planned total cash receipts from credit customers (trade receivables). It would generally show: Opening balance, Sales revenue, Cash receipts and Closing Balance. The opening and closing balance would represent the amount that the business is planning to owe by credit customers at the beginning and the end of each month.
Trade payables budget
These will show the planned amounts owned to suppliers at the beginning and the end of each month, including budgeted credit purchases each month and planned total cash payments. It would include: Opening Balance, Purchases, Cash payment and Closing balance. The opening and closing balance represents the amounts being owned by the organisation to suppliers at the beginning and the end of each month.
Inventories budgets
It would show the budgeted amount of inventories to be held by the business at the beginning and the end of each month. It would show the planned total inventories purchases and planned monthly inventory usage. It would show the Opening Balance ( in £) Purchases, Inventories used and Closing Balance. The Opening and closing balances would represent the amount of inventories, at cost, planned to be held at the beginning and the end of each month.
A raw materials inventories budgets would follow similar patterns, and a finished inventories budget would be similar. There is no reason why the inventories should not have been valued on the basis of either direct cost or variable costs as it should provide more useful information to the managers.
Non-financial measures in budgeting
The efficiency of internal operations and customer satisfaction levels have recently become critical for organisations in the competitive environments. Key performance indicators are being established including customer/supplier delivery times, machine set-up times, product defect levels and customer satisfaction levels. Non-financial measures are also used and brought into the budgeting process and reported alongside financial targets for the business.
Achieving the control
Budgets provide basis for achieving control across the business. It allows to establish on why the performance is not going in accordance to plan as it might be necessary to revise the budgets so that the targets become achievable. Unrealistic budgets cannot form the basis for exercising control doe to unexpected changes in the commercial environments. Managers can focus on areas where things are not going according to plan.
Measuring variances
The most important budget is to meet the profit targets.
If the budget profit is not achieved we may seem out of control. Management must discover on where things went wrong and ensure that mistakes are not repeated. The actual levels of output were are not as budgeted, but the costs might not be as budgeted as well.
Flexing the budget simply means revising it. We need to know which revenues and costs are fixed and which are variables relative to the volume of outputs. The sales revenue, materials costs and labour costs vary strictly with volume, but fixed overheads will not. Where labour costs are fixed we can take steps of the flexing process.
Flexible budgets allow to make more direct comparisons between the budget and the actual results for each aspect of the business that can be calculated. for example if actual profits were 10% less, we flex the budget to 10% less. The difference between the original budget and the flex budget would the be volume of sales and everything else would be the same. The difference is known as variance. Variance means that there is a difference between the actual results then the budgeted results. If the difference has an effect on making profits it is known as "adverse variance". Where a variance has an opposite effect it is called a "favourable variance". Only the sales revenue factor is taken into consideration as other factors may go according to plan.
There are, of course, reasons why the profits may not be achieved. There may be losses due to sales revenue shortfalls. Now the budget is flexed and the variance arising from sales volume difference is being stripped out of 10%. We may find out that the loss in profit may not be the only one concerning area. We can examine the revenue, materials and labour and compare the flexed profit budget with the actual values of each of the items.
We can determine that there are other favourable variances, such as sales price, direct labour, or adverse variances such as sales volumes, direct materials, fixed overheads that affect the actual profit.
The variance between flexed budget sales revenue and actual sales revenue may only arise from higher prices. This is because any variance from volume difference has already been isolated in the flexing process. If, for example, less was spend on labour, more was spent on materials and overspent on fixed overheads.
We would be concerned on how large the variances are and their direction (adverse or favourable). But we might be selling fewer units because of the increased prices. When other variances are reviewed it is reasonable to check these are significant to be concerned about. We may calculate the % rate of each variance to the budgeted profits so see it clearly. When the profits are concerned, we may investigate the direct materials variance or total direct labour. Overhead variances can also be broken down further.
Many businesses use budgets and variance control to help keep control of the activities. Generally managers seek explanations to variances arising in each branch/department.
How do we make budgetary control effective?
There must be routines put in place to exercise control. The organisations who exercise effective budgetary control have few things in common:
* A serious attitude taken to the system. This applies to all levels of management staring at the top.
* Clear responsibilities across managers. It is clear which manager is responsible for what so that accountability is defined.
* Budget targets are challenging but achievable.
* Establish data collection, analysis and reporting. This should be part of regular accounting system to calculate and report the variances produced each month.
* Fairly short reporting periods. Typically one month long so that things cannot go too far wrong.
* Timely variance reports. Reports are available to managers short after relevant reporting period.
* Actions being taken to get operations back into control. Managers need to take actions to put things right in the future.
Budgets are prepared to affect the attitudes of managers and generally the existence of budgets motivate and improve performance. But unrealistic targets tend to have adverse effects on manager's performance.
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