10. BUDGETS AND BUDGETING
All businesses need to plan for the future. In large businesses such planning, usually known as corporate planning, is very formal while, for smaller businesses, it will be less formal. Planning for the future falls into three time scales:
— long-term: from about three years up to, sometimes, as far as twenty years ahead.
— medium-term: one to three years ahead.
— short-term: for next year.
Clearly, planning for these different time scales needs different approaches: the further on in time, the less detailed can be the plans. In the medium and longer term, a business will establish broad corporate objectives. Such corporate objectives do not have to be formally written down, although in a large organization they are likely to be; for smaller businesses, corporate objectives will certainly be thought about by the owners or managers. This is very similar to ea6h one of us having personal objectives, which we are likely to think about, rather than write down.
In this unit we are concerned with planning for the more immediate future, i.e. the next financial year. Such planning takes the broader corporate objectives and sets out how these are to be achieved in the form of detailed plans known as budgets.
A budget can be defined as a planning and control tool relevant to the management of a business.
The main purposes of budgeting are:
— to assist in the assessment and evaluation of different courses of possible action;
— to create motivation by expressing a proposed plan of action in terms of targets;
— to monitor the effectiveness of performance being accomplished against the budget, and to report variances. Most budgets are prepared for the forthcoming financial year, and are usually broken down into shorter time periods, commonly monthly.
This enables control to be exercised over the budget: as time passes by, so the business' actual results can be compared to the budget; discrepancies between the two can be investigated.
The end result of the budgeting process is the production of a master budget which takes the form of estimated operating statements (manufacturing account, trading account, and profit and loss account) together with an estimated balance sheet at the end of the budgetary period. However, before the master budget can be produced, a number of subsidiary budgets covering all aspects of the business need to be prepared, e.g. sales, purchases, production, overheads, and cash. It can be seen that sales is, for most businesses, the starting point for the budget; this is because sales is often the limiting factor. A limiting factor is some aspect of the business which prevents further expansion. Other limiting factors include shortages of: raw materials skilled labour factory space capital expenditure on research and development.
Whatever the limiting factor, the budget needs to be designed to incorporate any restrictions imposed by the factor.
The planning of a budget is coordinated by a member of the accounts department. However, managers of individual departments are made responsible for preparing budgets for their own departments. Many larger organizations take a highly formal view of planning the budget and form a budget committee.
An important aspect of budgetary planning is to test for feasibility before submitting the master budget for the approval of the owner or board of directors. The test of feasibility would check, for example, that the sales budget and the production budget are linked together (so that stock-piling or stock shortages do not occur), that the production budget is within the capacity of the facilities available, that the cash budget does not show excessive short-term borrowing which could be avoided by rescheduling major purchases.
Once a budget has been approved by the owner or, in the case of a limited company, by the board of directors it becomes the official plan of the business for the period of the budget. There is no point in a business spending a lot of time and effort in preparing a budget if it is not used as a control mechanism throughout the period: this aspect is known as budgetary control.
The main aspect with which budgetary control is concerned is in comparing actual results with what was planned to happen in the budget.
Advantages of Budgets Performance targets are established. The process of budgeting establishes targets:
— for the business as a whole — in the form of a master budget
— for section managers — in the form of subsidiary budgets
— Comparisons can be made of budget and actual performance
— By comparing the budget with what happens in reality allows:
— management to know that a variance has occurred
— an investigation to take place into the causes of the variance
— action to take place to correct the reason for the variance.
Planning is beneficial
It is too easy for a business to meander along from day-to-day and week-to-week without any real idea of where it is going. A budget forces the management to think ahead and this, in turn, leads to better use of the resources of the business.
For a budget to be useful to business, it must be a realistic forecast of what can be achieved. If it is not, then the people who have to work to the budget will simply 'give up' and will not try to achieve the targets set. At the same time, the senior management of the business, starting at the top with the owner or board of directors, must be convinced of the usefulness of the budget. If budgeting is seen as a necessary chore to be undertaken without much enthusiasm, then this attitude will soon permeate down through the organization.
Fixed and Flexible Budgets. A fixed budget is one that is set at the start of the budgetary period and remains unchanged whatever the level of activity. For example, a budget is set for production of 10 000 units each month; actual production is 9 000 units per month. A fixed budget will compare the budgeted costs of producing 10 000 units with the actual costs of 9 000. Therefore the total variable costs, i.e. the actual figures, will be different from those budgeted for.
A way of overcoming the difficulty caused by a fixed budget is to use a flexible budget. This recognizes the different behaviour patterns of fixed costs and variable costs, depending on the level of output. Thus, an amended budget is produced on the basis of costs expected to be incurred at different production levels. For instance, in the example given above, a flexible budget would be produced for a production level of 9 000 units per month — the variable costs, e.g. materials, labour, and parts of the overhead, would be altered or 'flexed' to a level of 9 000 units. Then the actual costs can be directly compared with those of the flexible budget.
Zero-based Budgeting. The starting point for most budgets is to commence with last year's budget and then to add a few per cent to allow for inflation'. Such a policy, which is particularly prevalent in local and public authorities, has the major disadvantage that inefficiencies, provided they take place within the terms of the budget, remain in the system.
One way to avoid this is to use zero-based budgeting. With this system, the budget starts from zero, and each item going into the budget has to be justified on the basis of business activity. For example, a stationery budget for an office, instead of starting with last year's figure and 'adding a bit', will start at zero and the manager of the office must justify each item which goes into the budget. The advantage of such a system is that managers have to justify their own budget.
Cash Budget. The cash budget is the subsidiary budget that brings together all the other individual budgets. From a cash budget (which is often known as a cash flow forecast) can be produced the master budget. (This takes the form of forecast financial statements, i.e. projected trading and profit and loss account, and balance sheet.
The purpose of a cash budgets to detail the expected cash and bank receipts and payments, usually on a month-by month basis, for the next three, six, twelve months (or even longer), in order to show the estimated bank balance at the end of each month throughout the period. From the cash budget, the managers of a business can decide what I action to take when a surplus of cash is shown to be available or, as is « more likely, when a bank overdraft needs to be arranged.
Limitations. While a cash budget is a very useful guide, it is only as good as the estimates on which it is based. A cash budget which is based on optimistic sales for the next six or twelve months will show an equally optimistic picture of the bank balance; a budget that looks too far into the future will probably prove to be inaccurate in later many cash budget and cash flow forms have. To supplement the cash budget, it is quite usual to prepare a master budget, in the form of forecast final accounts.
As we have seen just now, a cash budget is prepared on the basis of certain assumptions, for example:
— debtors pay, in full, in the month following sale
— purchases from suppliers are paid for two months after the month of purchase
Often the managers of a business will wish to change the assumptions on which the cash budget is based by saying 'what if?' For example:
— we buy a new machine three months earlier than planned?
— What if we What if half our debtors take two months to pay?
— What if take advantage of cash discounts offered by our creditors and pay within, say, 14 days of purchase?
Each of these examples will change the cash budget substantially, and any two of the three, or all three together, is likely to have a considerable effect on a previously calculated budget, and may lead to an increased bank overdraft requirement.
To answer 'what if questions, the whole cash budget has to be reworked on the basis of the new assumptions. The reason for this is that, as the estimates of receipts and payments change each month, so the estimated closing month-end bank balance changes. This is where a computer spreadsheet is ideal for the preparation of cash budgets: each change can be put in, and the computer can be used to rework all the calculations. A printout can be taken of each assumption and then passed to the managers for their consideration.
Cash: a limiting factor. It might be that the cash budget shows, for certain months, a potential bank overdraft which is beyond the limits of the business. It might be unacceptably high for the business because of the interest cost, or the bank may not be prepared to allow such overdraft facilities. Thus a shortage of cash may be the limiting factor for a business, and it may have to rethink the other budgets in order to change its plans so as to work within its cash resources. After all, it is a shortage of cash that forces most companies into liquidation, even if they provide a good product or service: thus the efficient use of cash resources is one of the most important control aspects for the management of a business.
Points to note when preparing forecast final accounts:
— The sales figure shown in the trading account is the total amount of goods sold, whether paid for or not (sales made, but not yet paid for, are recorded as debtors in the balance sheet).
— Likewise, the figure for purchases is the total of goods bought, with amounts not yet paid for recorded as creditors in the balance sheet.
— Depreciation, which never appears in the cash budget, is shown amongst the expenses in the profit and loss account, and deducted from the cost of the fixed asset in the balance sheet.
(Note that, in the example above, depreciation is for a period of six months.)
Comments on Cash Budgets and the Master Budget
Besides preparing the cash budget and master budget, you may need to comment on them, either to the owner of the business, or to a potential lender. It is therefore vitally important that the subsidiary budgets used in the preparation of the cash budget are accurate, as anything that follows will be 'thrown' by an inaccurate budget.
You may need to prepare answers to the following questions:
— Will bank finance be needed at any time during the period covered by the cash budget? If so, how long will it take to repay such borrowing?
— Is there a build-up of cash that needs to be invested on a short-term basis?
— Is the business profitable?
— Are the credit terms allowed to debtors similar to those received from creditors?
— How much is the owner taking out of the business in relation to the forecast net profit?
— If the purchase of fixed assets creates a large overdraft, could other forms of finance be considered, e.g. hire purchase, or leasing?
In addition to these points, ratio analysis can be used to analysis the forecast final accounts, and comparisons can be made with what was achieved by the same business in the previous year or half-year (assuming it was then trading).
