topic 35 budgeting

• A budget is a short term financial plan. It calculates financial information for the immediate future. CIMA defines a budget as a 'plan expressed in money'
• Benefits of budgeting:

  • planning - allows managers to prepare for the future and set down projected figures so the business is organised
  • coordination - individual departments are inter-dependant, there is a need to ensure that individual budgets do not conflict
  • communication - managers communicate with sub-ordinates
  • control - budgets will be compared with actual results so that remedial action can be taken if actual results<budgeted results
  • decision making - forecasting means that decisions have to be made
• Limitations of budgeting:

  • inaccurate data - all budgets are based on estimates which by definition might not actually happen, some managers may be over pessimistic or too pessimistic
  • departmental rivalry - creates competition between departments and may lead to a lack of cohesion and cooperation
  • demotivating - if budget is unrealistic, employees and departmental managers will be demotivated, and if too easy workers will slack
  • over-riding goal - budgets may become an over-riding target in firms so they lose sight of core objectives
• Budgets can be set using:

  • incremental budgeting - based on previous figures
  • zero budgeting
• The sales budget:

  • shows expected sales in units, and/or sales revenue
  • is usually the first one to be prepared because all the other budgets are based on forecast sales which depend on factors such as: changing customer tastes, competitor's actions, the economy and govt policy
• The production budget:

  • prepared if the business is a manufacturer
  • calculates how many items have to be produced in units
• To calculate how many units need to be produced in each period: Estimated sales + Estimated closing inv - Opening inv = Units to produce
• Benefits of preparing a production budget:

  • should mean production is planned which would help to avoid having excess inventories or large variations in production levels which could cause problems with labour usage/costs or storage problems
  • planning production will help to ensure sales targets can be met
  • will allow coordination with other departments
• The purchases budget:

  • similar to production budget except it calculates purchases of finished goods for a trader or raw materials for a manufacturer
• Calculating purchases from sales:

  • when sales figures are given in pounds rather than units, this will be based on the volume of sales X selling price, however a purchases budget will be based on cost price
  • it is therefore necessary to use the mark up or margin in order to convert sales figures to purchases
• Trade payables budget:

  • when a business buys supplies on credit, the purchases budget will be linked to a separate trade payables' budget and payments for purchases will not be perfectly synchronised
• Trade receivables budget:

  • when a business sells goods on credit, the sales budget will be linked to a separate receivables' budget because sales and receipts from customers will not be perfectly synchronised
• Labour budget: is prepared to show the estimated hours of labour needed to produce the budgeted levels of production so is prepared after the production budget
• A labour budget is used for:

  • budgetary control to control the cost of labour
  • coordination with the production budget and cash budget
  • coordination with the human resources department for workforce planning such as recruitment of additional staff or planning work patterns eg. shifts
• Cash budget - shows estimated receipts less payments so that managers can anticipate any possible shortage or surplus of cash and make suitable arrangements
• Purposes of a cash budget:

  • to make sure that the business plans ahead so that it has enough cash available to operate and pay bills on time, cash flow problems are the major cause of business failure
  • to alert managers to possible shortages so that they can take action beforehand
  • to highlight times when the business will have cash surpluses which can be invested short term to gain interest
• Benefits of budgetary control:

  • planning - should mean that the business will be prepared for events that could happen in the coming year therefore is less likely to have cash flow problems
  • monitoring - can compare actual results with budgeted to control any significant variances
  • control - expenditure could be limited to avoid exceeding overdraft limit
  • coordination - help all staff to work towards the goals set by senior management, should improve business performance
  • raising finance - a cash budget will help support a request for a bank loan
• Limitations of budgetary control:

  • inflexibility - budgets can be restrictive and prevent improved business performance as staff focus on budgeted targets rather than what is best for business
  • time consuming - can be very time consuming to prepare and monitor and business may neglect other areas
  • based on forecasts - forecast may be inaccurate leading to poor decisions
  • demotivating - can demotivate staff if they're not involved or target is unachievable
  • lack of experience - if managers don't have experience with a budgetary control system, could lead to problems
• Incremental budgeting is a method of setting budgets in which the prior period budget is used as a base for the current budget, which is set by adjusting the prior period budget to take account of any anticipated changes
• Zero budgeting is the process of creating a budget from nothing, without using the prior year's budget or spending numbers
• Advantages of incremental budgeting:

  • easy to implement - does not require any complex calculations
  • realistic - based on actual results
  • stability - no large deviations are seen in the budget year after year as it gradually changes the budget requirement
  • reduces rivalry between departments - all departments are given a similar amount of increase over previous year
  • suitable for companies where funding requirements are fixed or have little deviation
• Disadvantages of incremental budgeting:

  • circumstances may have changed which means much more significant budget changes
  • does not encourage efficiency, may lead to lack of innovation and no incentive for managers to reduce the cost
  • may make managers spend more as budgets may be easily available and may lead to unnecessary spending of funds
  • can cause perpetual resource allocation to certain departments even if they may not need them in later years causing waste of resources and depriving other units of funding requirements
• Advantages of zero budgeting

  • Up to date - based on current not historical information
  • Accuracy - makes every department look again at each and every item in the budget and calculate costs involved starting from a zero base, helps to reduce costs to an extent
  • Efficiency - helps in efficient allocation of resources as resources will only be allocated if they meet demands of the department
  • Reduction in redundant activities - leads to identification of opportunities and more cost effective ways of doing things by removing all unproductive activities
  • Budget inflation reduced - overcomes weakness of budget inflation in incremental budgeting, where costs are increased in line with inflation from previous year's figures
  • Motivation - employees have more ownership, more motivation
• Disadvantages of zero budgeting:

  • makes budgeting more complicated and time consuming
  • less money will be allocated to some departments causing less cooperation between managers
  • lower budgets may demotivate