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Budgeting

BUDGETING

 A Budget is a plan expressed in financial terms.

 C.I.M.A. defines a budget as ‘A plan quantified in monetary terms, prepared prior to a defined period of time... to attain a given objective’, A budget is normally for a relatively short period, e.g. 1 year.

Purposes of Budgeting

 A number of purposes of budgeting have been identified. They include:

  1. Planning.
  2. Resource Allocation.
  3. Co-ordination.
  4. Control.
  5. Communication.
  6. Motivation.
  7. Performance Evaluation.

Budgetary Control

 This is a system which uses budgets as a means of controlling the activities of the organisation. It has three main aspects:-

    1. Planning.
    2. Co-ordination.
    3. Control.

Planning

 Budgetary planning is the process of preparing detailed, short-term plans for all the functions, departments and activities of the organisation. It is important that the short-term plans and objectives that make up the budget are related to the long-term plan and objectives of the organisation. The budget may be drawn up by preparing an overall budget for the organisation which is then broken down into more detailed budgets for the different parts of the organisation [the top-down approach] or by devising budgets for the various parts of the organisation and then bringing them together to build up the overall budget [the bottom up approach].
 
 

Extrapolations, Forecasts and Plans

 In discussing budgetary planning it is important to distinguish between extrapolations, forecasts and plans.

 An extrapolation is the continued projection of an existing trend.

A forecast will be based on an extrapolation, but is adjusted to take account of any known factors which will affect the trend.

 A plan involves some intervention by the organisation in order to modify events in such a way as to make it more likely that the organisation’s objectives will be achieved.

Co-ordination

 It is vital that the plans of each department are related to each other and are integrated together to make a coherent whole e.g. it is no use planning for sales of 150,000 units if productive capacity is restricted to 120,000 units. Note the significance in this context of limiting factors and the principal budget factor.

 The principal budget factor is the factor which acts as an over-riding limitation on the activities of the organisation. It might be sales, productive capacity, finance, shortages of materials, labour or energy. The principal budget factor can change over time. Identifying limiting factors is a key element in the co-ordination aspect of budgetary control.

The Master Budget

 This is the overall plan for the business’s financial activities, to which, therefore, its

sectional plans must be related. For commercial organisations it will be normally in the form of a planned Income Statement, Balance Sheet and Cash Flow Statement.

 The master budget is the key element in budget co-ordination as it summarises all the other plans and reveals any inconsistencies amongst them.

Control

 As far as possible, actual Activity should be in line with the original plan and steps should be taken to restore Activity to the plan when there are deviations from it [although on occasions it will be necessary to adjust the plan to meet changing circumstances].

 Control is exercised in organisations by the continual feedback of information to facilitate such corrective action.

 Variations from plan are revealed by measuring actual performances and comparing it to planned performance. These variations [known as variances] are analysed in more detail and reported to managers for action. NB taking action on variances is the key part of the control mechanism. It is important therefore, that information [in the form of budgetary reports] is timely, relevant and comprehensible.

 We shall discuss the control aspects of budgeting in more detail in the next session.

We can sum up the purposes of budgeting as follows:

 It has been claimed that the operation of a budgetary control system within an organisation can be valuable in a number of different respects. These include:-

Planning

 The budget is a useful way of setting out in detail the planned activities of the organisation for the coming period and relating them to the objectives of the organisation.

Resource Allocation

 The budget can be an instrument by which a fair and efficient allocation of resources may be achieved. Without a coherent budget; resources may be allocated indiscriminately with consequent detrimental effects on the organisation as a whole.

Co-ordination

 A carefully prepared budget should help to co-ordinate the organisation’s activities and resources. For example, production must be co-ordinated with sales; purchases of materials and labour with production; and stocks of materials with production requirements, storage facilities and the cash available.

Control

 The budget is vital in comparing actual performance to planned performance and enabling corrective action to be taken when deviations occur.

Communication

 Budgets have an important part to play in the communication of objectives, targets and responsibilities throughout the organisation. Carried out properly, this can have considerable benefits in promoting co-operation at all levels.

Motivation

 By setting challenging but realistic targets well designed budgets can play a significant part in motivating managers. The targets must be clear and achievable, and the manager should participate in setting his or her own budget.

Performance Evaluation

 The budget gives senior management a means of judging the performance of their teams. It must be remembered, however, that adherence to the budget alone cannot measure all aspects of a manager’s performance.

Budget Planning
 
 

In order to carry out budgetary control, it is necessary to formulate a fully co-ordinated detailed plan in both financial and quantitative terms for a forthcoming period. The duration of the period is usually one year. The plan needs to be in line with the long term development strategy of the organisation, although in the shorter term of a budget year, conditions may prevail which could dilute this aim. For example a depressed economy could lead to a temporary departure from the long term plans. Therefore, before formulating the budgets, the policy to be pursued during the forthcoming trading period needs to be established.
 
 

Once budgets are operating throughout an organisation, it is important that feedback is made available to the managers responsible for its operation. This is often done by means of monthly budget reports. These reports contain comparisons between the budget and the actual position and throw up differences which are known technically as variances.
 
 

There are two major aspects to budgetary control; planning and control. [We will focus on Control in the next session].
 
 

Planning - The budget is a corporate plan that sets out in detail the financial and/or quantitative objectives of every department and Activity within the organisation, and reconciles them in an overall plan. The plan needs to be internally consistent.
 
 

In drawing up the plan one of the first actions needed is to identify the Limiting Factor. As the name implies this is the factor which will limit the size and scope of the company’s operations. In order to produce an internally consistent plan, the budget will need to be built around and reconciled to the limiting factor.
 
 

Before proceeding further into the area of planning, a distinction needs to be drawn between a budget and a forecast. One of the prime reasons for formulating budgets is to try to attain future objectives by means of a co-ordinated detailed plan. In other words budgets are drawn up with a view to influencing the course of future events. On the other hand, a forecast is simply a prediction of future events assuming that present trends will continue, or that they will be modified by foreseeable factors.
 
 

There are several benefits that can accrue from careful detailed planning.
 
 

  1. The environment in which the organisation operates is monitored, and plans prepared accordingly.
  2. Long term objectives are kept firmly in view, and steps taken to ensure that the present budget [as far as possible] is kept in line with them.
  3. Under the heavy pressure of day to day operations, management doesn’t lose sight of future requirements.
  4. Management makes a conscious effort to look for, and/or to create new opportunities, and to exploit them.
  5. A wealth of information is made available to management, on which financial decisions can be made, and the effects of alternative courses of action can be addressed.
  6. A short term profit plan is prepared in detail which is acceptable to management.
  7. Management can ascertain that adequate resources are available to carry out the plan, and that as far as possible optimum use is made of them.

Budget Preparation
 
 

The Budget Period - This is the period of time for which a Budget is employed. The period varies depending on the type of Budget.
 
 

Examples: (a) Trading Budget [say] 1 year.

      1. Capital Expenditure Budget [say] 5 years.
      1. Research and Development Budget [say] 5 years minimum.

It should be borne in mind, that if a Budget is for more than one year, that the chances of it being modified are extremely high.
 
 

Although the overall Budget may be for a year or more, it is always broken down into shorter periods. Budget periods in excess of one year would be broken down into annual amounts, and the annual amounts would be further sub-divided into monthly accounting periods. Budgets which are compiled for the duration of one year, would similarly be broken down into accounting periods.

 Having arrived at the amounts for each period, the actual expenditure incurred during a period can be compared with the appropriate Budget and Variances extracted.

Types of Budget - There are two basic types of Budget:
 
 

  1. Operating Budgets - These relate to the day to day operating of the enterprise.

Examples: (a) Sales Budget

a.       Manpower Budgets

a.       Revenue Expenditure Budgets

d.      Short Term Cash Budgets

  1. Capital Expenditure Budgets - Capital expenditure is expenditure that is committed in the acquisition of long lived [or fixed] assets. These assets take the form of such items as:
    1. Premises
    2. Plant and Machinery
    3. Lorries, Vans, Cars
    4. Office Equipment [Desks, Typewriters, Computers].

These budgets are inter-related. (See Chart on PXX)
 
 

Designing and Operating a Budgetary Control System
 
 

The procedures will vary from one organisation to another, but a general pattern can be established as follows:-
 
 

  1. Forecasts are made to cover e.g.
    1. Sales
    2. Production
    3. Stocks
    4. Costs:-
      1. Production
      2. Selling and Distribution
      3. Administration
      4. Research and Development
    1. Capital Expenditure
    1. Cash
  1. Alternative combinations of forecasts are compared. Principal budget factor and limiting factors are considered. That combination of forecasts which is most likely to achieve the objective(s) is chosen.
  1. Budgets are prepared to cover the items in (1) above. The activities of the organisation are integrated into a complete plan [The Master Budget].

NB It will take a number of attempts before the budget is finalised. Thus budgeting is a reiterative process.

Budget Centres
 
 

Costs are best controlled at the point at which they occur. Suitable areas of control must be selected and they should not be too large. Examples might be workshops in a factory and wards in a hospital. The areas selected should comply with the responsibilities of supervisors and managers. These areas are known as budget centres [or cost centres] and the budgets are attached to them as departmental budgets. It will also be necessary to have budgets prepared to summarise the performance and costs for each function. The departmental budgets are then integral parts of the functional budgets.
 
 

The Master Budget is the overall plan which summarises and is derived from the functional budgets. It integrates the supporting budgets and is the corner-stone of the co-ordinating process.

Responsibility Accounting

 The budgetary control process places great emphasis on the location of responsibilities within the organisation. The recognition that performances can be traced to managers, supervisors and workers is an integral part of budgetary control therefore, to distinguish clearly between controllable and uncontrollable costs. Controllable costs are those which can be traced to a particular person or group of persons. It would be unfair to hold a manager responsible for costs which are outside his or her control.

 Responsibility accounting enables management by exception to be practised, i.e. managers are given information only on matters not going to plan.

Fixed and Flexible Budgets
 
 

A fixed budget is ‘a budget which is designed to remain unchanged irrespective of the volume of output or turnover attained’. CIMA Terminology. It is of limited value, therefore, for control purposes. A flexible budget is one which is designed to adjust the budgeted cost levels to match the level of Activity actually achieved. It thus recognises the difference between fixed and variable costs in relation to output and is designed to change appropriately.

Extra Reading

BUDGETARY CONTROL
 
 

Budgets need to be formulated along the lines of executive responsibility. The organisation requires to be sub-divided into its major constituent parts as represented by the senior management functions, or example - Production - Marketing - Distribution - Personnel - Finance and Administration. These major areas need to be further sub-divided into their constituent parts, again along the lines of management responsibility, and this sub-dividing will continue through each descending tier of management. Care needs to be taken to ensure that the fulfilment of every part of the budget is the direct responsibility of a designated manager, and that dual or overlapping responsibility for an operation is avoided.
 
 

Then control is applied in two stages:
 
 

  1. By the preparation of budgets along the lines of executive responsibility. This ensures that every area of the budget is the responsibility of some designated executive who will oversee its operation, and will be accountable for the achievement of the budgeted levels of performance.
  2. By the constant monitoring of actual performance against the budget, and the determination of variance from budget. The results of these comparisons are reported to the executives responsible for each area of the budget. This is known as responsibility reporting. All significant variances, whether they are favourable or adverse, need to be investigated. [A significant favourable variance indicates a departure from the original plan]. What is significant is a matter of subjective judgement, but will probably take into account such factors as:
    1. The absolute size of the variance - is it large enough to worry about? There is little point in spending valuable time investigating a small variance.
    2. The proportionate size of the variance - a variance which shows [say] a 20% under/overspending may require further inquiries.
    3. It is part of a trend over time that shows a continuing deterioration?

The use of variances enables a manager to adopt the technique of management by exception, concentrating his efforts on the parts of the plan that are going wrong and thus using valuable time efficiently.
 
 

The basis of control is the circulation of management information. The problem is, accountants can produce the information but they cannot make managers use it. Therefore, a very relevant question is, what factors can encourage managers to use the information supplied?
 
 

There are several factors, besides the relevance of the information that determines whether or not management information is used by managers.
 
 

The information needs to be presented with clarity. It needs to be readily understandable, it needs to point to the need for action, and it should highlight significant changes. It should be in sufficient detail to enable managers to make use of it, but excessive detail needs to be avoided.
 
 

Managers are more likely to use management information if it is presented with timeliness. Information, to be of value, needs to be presented as soon after the event as practicable. This has the double effect of relating to events which are still fresh in the manager’s mind, and giving an opportunity to take corrective action on adverse trends as soon as possible.
 
 

Levels of Attainment
 
 

The levels of expected performance which are set influence the motivation of managers responsible for target achievement.
 
 

If levels are set too high, then there is a strong disincentive to management involvement in the budgetary process, and a low level of motivation.
 
 

It levels are set too low, then managers can achieve targets easily despite inefficiencies. This is known as budgetary slack
 
 

Setting appropriate levels of attainment in budgets is a complex and difficult Activity with an important behavioural dimension.
 
 

Conflicting Purposes of Budgeting
 
 

As we saw in the last session, budgeting may serve a number of different purposes. There is a danger, therefore, that using the same budget for the various purposes may be unsatisfactory.
 
 

For example, a budget may be used for planning [as a forecast], for motivating [as a target] and for evaluating performance [as a yardstick].
 
 

A forecast needs to be realistic but a target needs to be demanding. A target should be challenging but a yardstick must be fair. A forecast, while it should be plausible, will be prepared in advance of the period, but a yardstick should be based on the most up to date information as to what is achievable.
 
 

Thus it has been suggested there should be two budgets:
 
 

  1. A budget for planning and decision-making based on reasonable expectations.
  2. A budget for motivation with more difficult targets.

The question then arises which budget would be used for performance evaluation? Budget holders would argue understandable for the first, but then would the second retain its power to motivate?
 
 

Benefits and Limitations of Budgeting
 
 

Budgeting is a form of planning and control system found in most organisations of any size, in both the public and the private sectors. There are benefits to be gained from the process, but they do not come automatically. It is important, therefore, to be aware of the problems which may be encountered and to re-appraise the system constantly.
 
 

Benefits of Budgeting
 
 

These include:-
 
 

  1. The organisation’s objectives are identified and turned into specific plans, Activities and objectives, related to specific manager’s responsibilities.
  1. The communication of the organisation’s plans and objectives, and of the progress towards meeting these.
  1. The detailed examination of the organisation’s structure and cost behaviour necessary for budgeting, highlights strengths and weaknesses and indicates potential areas for cost reduction.
  1. Co-ordination between the department and functions of an organisation will be improved by a good budgeting system.
  1. The development of routine management in setting budgets and accepting targets should lead to increased motivation.
  1. Performance is reported and monitored thus aiding control.
  1. Variance analysis reveals the nature of any weaknesses. It indicates areas for further investigation and points to the corrective action to be taken.

Limitations of Budgeting
 
 

These include:
 
 

.1. The budget system may cause antagonism and poor motivation [due to undue pressure, poor human relations etc].
 
 

  1. Variances are frequently due to changed circumstances, poor forecasting etc., rather than management performance.
  1. Budgets reflect the current organisation structure which may not be optimal, especially during rapid change.
     

 

  1. There is a danger of inertia and inflexibility because of an unwillingness to change well established plans.
  1. There are considerable difficulties in setting appropriate levels of attainment.
  1. There is the problem of time lag in the system [e.g. June’s results are not available until late July, are reported in August and are compared to forecast made months earlier].
  1. The technique should not be relied upon as a substitute for good management.

Conditions for Successful Budgeting
 
 

  1. The involvement and support of top management.
  2. A clear definition of long term objectives and their communication. Short term plans must be linked to long term objectives.
  3. A realistic organisation structure with clearly defined responsibilities.
  1. Genuine involvement of managers in all aspects of the budgeting process.
  2. An appropriate accounting information system. This requires:
    1. The recording of performances in relation to responsibilities.
    2. Prompt and accurate reporting of results.
    3. The ability to provide more detailed information and advice on request.
  1. Budgets should be administered in a flexible manner. Significant changes in circumstances should lead to changes in plan. Rigid adherence to budgets which are inappropriate for current conditions leads to loss of credibility and effectiveness.


 
 



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