P1 Management Accounting

Module: 07

Budgeting Techniques

Budgeting Techniques

1. The purpose of budgeting

It's pay day and you and your friends hit the town with your wages already burning a hole in your pocket. You get to the bar and take a look at the menu. One of your friends suggest you all get champagne tonight, champagne is priced at £30 a glass whereas wine is £7 and beer is £4. It occurs to you that you have your mortgage payment due next week, the kids' birthdays and you need to fix the car.

You have more than enough money for a few glasses of champagne, but will you have enough for the champagne AND the mortgage AND the birthday presents AND the car repairs? As much as you would like a glass of champagne you go for the beer instead to ensure you have enough money for everything else. This is budgeting.

A budget is a financial plan of operations, which serves as part of the planning and control process. The purposes of budgeting are:

Planning

Planning is essential in all organisations. Without a plan manager will not be aware of their goals and objectives. This ultimately leads to poor performance. Preparation of budgets helps provide defined targets for managers to achieve, and the budget setting process itself forces

Budgeting Techniques

management to plan ahead.

Responsibility

A budget gives managers authority to spend money and incur expenditure. However, it also presents them with the responsibility to manage this expenditure, ensuring it is controlled and spent with the organisation’s best interests in mind.

Co-ordination

A budget is a formalised plan for achieving the organisation’s goals. With this in place, managers are aware of how their operations relate to other departments, ensuring everyone moves in the same direction. This co-ordination and communication between different departments is often a critical part of maximising efficiency.

Motivation

Budgets are an excellent tool for measuring performance and setting remuneration levels, which serves a source of motivation for staff.

Control

The ability to compare actual results with budgeted targets is a powerful control tool for assessing the organisation’s success in reaching its goals.

Conflicts

Often these purposes can lie in conflict with one another. For example, it is important that budgetary targets are motivating for employees, encouraging them to strive for the best possible results. However, for control purposes it is best that targets are neutral, set at reasonable, achievable levels. In this case the conflict lies in setting a budget at the normal, attainable level or setting targets slightly higher to encourage work above and beyond the usual standard.

2. Budget preparation

The budgets used by organisations will be far larger and more complex than the rough budgets you may memorise or jot down on a piece of paper for your monthly expenses. They will often need to contain information relating to dozens of different departments and may affect the working lives of thousands of employees. There are several components that are essential to preparing effective budgets within organisations.

Budgeting Techniques

Co-ordination

All functions of an organisation are interdependent and so the budget of one department will undoubtedly influence others. For example, it is difficult to determine a budgeted level of material purchases without a budgeted level of production. Similarly, a budgeted level of production cannot be set without a budgeted level of sales. Therefore, it is imperative that budgets are formed via the use of a budget committee, which should include representatives from each part of the organisation. Collaboration between these representatives will ensure that a co-ordinated approach is taken.

Information

It is essential that all information required for the budgeting process is accurate and available to the budget committee. This includes current results and figures, the budgetary process, the organisation’s targets, and details of who is responsible for each function. This information is usually brought together in a budget manual.

Identification of the principal budget factor

Before the budget setting process begins the principal budget, factor must be identified. The principal budget factor is the bottleneck factor in the organisation.

For example, if production capacity is limited then production capacity will be identified as the principal budget factor. Therefore, the production budget will be prepared first, and all other budgets based around it. Failure to identify this factor will lead to all departments working towards targets that are unattainable due to the bottleneck in the system.

This not only illustrates the importance of identifying the principal budget factor, but also reaffirms the point that budgets for all functions and departments are interrelated and must be prepared together.

Master budget

The completion of all budgets will result in the preparation of a master budget – a summary of all functional budgets. Typically, this will include a budgeted profit and loss, budgeted balance sheet and budgeted cash flow statement. This is valuable for senior management who can use this information for more of a ‘big picture’ approach.

Let’s work through an example of preparing a typical operational budget:

Budgeting Techniques

Example:

Our toy car factory produces only one product. Materials required consist of plastics and metals. Labour required consists of machine staff and specialist staff. Standard costs for the year are as follows:

Direct materials Price/kg £ Kg per unit Plastics 2 24 Metals 5 10

Direct labour Rate/hour £ Hours per unit Machine staff 3 10 Specialist staff 5 6

Budgeted stock levels for the year have been decided as follows:

Budgeted stock Units Plastics (kg) Metals (kg) 1 January 400 30,000 25,000 31 December 500 35,000 27,000

Sales has been identified as the principal budget factor. The sales budget for the year is 2,400 units.

Budget should be based on the principal budget factor

We know that sales is the limiting factor of our business. This means we need to set other budgets based on the sales budget of 2,400 units. Let’s calculate our production budget based on this sales volume:

Sales required (units) 2,400 Closing stock 500 2,900 Less: Opening stock 400 Production budget (units) 2,500

Budgeting Techniques

We can now calculate our materials and labour budget, which will be based on our production budget:

Direct Materials Plastics Metals Required to produce 2,500 units (kg) 60,000 25,000 Add: Budgeted closing stock (kg) 35,000 27,000 Less: Budgeted opening stock (kg) 30,000 25,000 Material purchases required (kg) 65,000 27,000 Price per kg £2 £5 Material purchases budget £130,000 £135,000

Direct labour Unskilled Skilled Required to produce 2,500 units (hours) 25,000 15,000 Cost per hour £3 £5 Direct labour budget £75,000 £75,000

Notice the importance of the early identification of the principal budget factor. Had we based our budget on production capacity, we might have budgeted for a much higher level of output; a level which our sales manager wouldn’t have been able to sell.

3. Incremental budgeting

It's pay day again. Last month you got out your calculator and worked out a budget. Out of your entire £1000 pay package, you budgeted for £600 of expenses, gave yourself a limit of £200 for disposable income and saved £200. Everything worked out well and you didn't run out of money!

This month, you've earned a small bonus of £20 from work and to save yourself time, you decide to use last month’s budget but add an extra 5% on to your savings and disposable income amounts.

On the plus side, you've saved yourself a few hours working out your budget for the month from scratch. However, on the downside, you might have missed an opportunity to save more money because you ended up putting more money into the disposable income fund than you really needed!

This is a simple example of how incremental budgeting works and its potential pro's and con's.

Incremental budgeting is a method whereby targets are set based on the current year’s budget or results. Organisations will usually start with this

Budgeting Techniques

year’s figures and then add an estimated amount to account for inflation and any amount of growth that could be expected.

Incremental budgeting has the benefit of being a simple method to implement, avoiding the in-depth analysis required by many other techniques. However, incremental budgets are only effective if the organisation is already operating at optimal efficiency, without opportunities for improvement in any areas of business.

In the fast-changing business environment of today, such a scenario is rather unlikely. Inevitably a budget will become aged and using an incremental budgeting approach the inaccuracies that eventuate will end up being carried forward year after year. For this reason, incremental budgeting is best suited for special cases, such as smaller or detached departments within an organisation, rather than being implemented within an organisation on the whole.

4. Zero based budgeting (ZBB)

Introduction

It's pay day once more! For the last few months you've based your budget on the month previous. It's worked out well and you've been able to live comfortably and save at the same time, but you've been getting the feeling money is being wasted somewhere, so you decide to do something about it.

Unlike previous months where you've been lazy and not bothered to estimate what your spending will be for the month, this month you carefully write out all of your expenses. When you add it all up, it quickly becomes apparent that you've been spending a great deal of your disposable income on takeaway food!

This month you give yourself £100 less disposable income (and save £100 more) as you plan on cooking your own meals for the entire month.

This is a simple example of what is known as “zero based budgeting”.

Zero based budgeting is a method whereby every item of expenditure must be fully justified before its inclusion in the budget. In effect this reduces the budget for all activities to zero at the start of each period, and the merits of receiving funding must be presented to the budget committee each year. This lies in contrast with traditional budgeting methods, which assume that current expenditure levels are already acceptable and only increases in those levels need to be scrutinised.

The general process in preparing a ZBB budget begins with the establishment of ‘decision packages’. A decision package consists of an activity. The manager responsible for this activity is identified and asked to

Budgeting Techniques

describe the costs and benefits of the activity in question, outlining the deliverables that are achievable and the levels of funding required. Each decision package is then ranked and prioritised based on its contribution to the organisation’s goals. It is upon these rankings that resources are then allocated.

ZBB is best suited to organisations with high levels of discretionary spending. Marketing and research are good examples of such costs. Organisations where direct manufacturing costs make up a high proportion of expenditure are generally ill-suited to ZBB. Obviously, it is impossible for manufacturers to operate on a zero budget for materials and labour, hence it would seem a waste of time to even consider the possibility.

Where ZBB flourishes is in the public sector, where organisations receive a fixed amount of government funding each year and are then required to allocate these funds in the most effective way possible.

Advantages of ZBB

Effective at identifying areas of inefficiency.

Funds are only allocated where clear benefits can be expected, rather than providing default allocations based on previous years.

Managers are forced to co-ordinate the highest levels of efficiency in order to secure funding.

Usually results in an effective allocation of resources

Disadvantages of ZBB

Creation of decision packages can be expensive and time consuming.

Ranking of decision packages is subjective and based on human discretion.

Decision packages that provide significant value in the long term can be overlooked in favour of those providing immediate benefit.

Budgeting Techniques

5. Activity based budgeting

You should now be familiar with the concepts of activity-based approaches and the idea of focusing on activities that drive costs rather than the actual costs themselves. Activity based budgeting is no different. This approach to budgeting involves identifying the activities that are driving costs, and then allocating funds based on the level of each activity. For example, a traditional budget for a delivery company might look like this:

Activity Cost £ Wages 300,000 Vehicle costs 190,000 Equipment costs 110,000 600,000

The problem with this method of budgeting is it does not take into account the reasons for the costs incurred and has little relationship with the activities that actually drive the costs. Therefore, the basis upon which these funds were allocated may be questionable.

An activity-based budgeting approach addresses these weaknesses by linking fund allocations to the actual cost drivers, and might look like this:

Budgeting Techniques

Activity Cost £ No. of activities Order processing 115,000 190,000 Local delivery 165,000 100,000 Rural delivery 235,000 60,000 Packaging 85,000 175,000

600,000

This approach provides a far better indication of how costs are incurred and in turn allows for a more accurate budgeting process. For example, if the number of rural orders is expected to rise by say, 2,000, management can accurately estimate the cost of this increase and budget accordingly. In contrast, a traditional system would have them estimating the extra labour hours, extra vehicle costs and extra equipment requirements of a rural order, all without understanding how much the actual activity of a rural order really costs.

As with all other activity-based techniques, focusing on the cost drivers goes a long way towards the most accurate allocation of costs possible.

6. Cash flow forecasting

Good cash management is essential to the health of a business. Even profitable businesses can find themselves struggling to survive if sufficient funds are not available when needed. This can lead to high financing costs, damaged customer/supplier relationships and lost investment opportunities from not having cash at the right time.

To facilitate good cash management, organisations use cash flow forecasts.

Imagine you have a large payment due in a month and minimal cash in the bank. A cash flow forecast will help determine whether sufficient cash will be received in the interim, or if a source of finance will need to be arranged. Without a reliable forecast, emergency finance will need to be sourced which can damage the banking relationship, or a late payment will be made which will damage the supplier relationship.

Similarly, if you have a large cash balance and have only forecasted minimal outflows for the coming 6 months, you can commit your funds to an interest earning account for that period of time, confident that your funds will be able to stay there for the entire term.

This ability to plan ahead means the organisation can make the most of its cash resources, while also avoiding the cash flow problems that can affect even the most profitable businesses.

Budgeting Techniques

7. Cash budgets

A cash budget is a detailed forecast of cash receipts and payments, used to determine the expected cash balance of a business over a certain period.

To illustrate the value of this let’s work through an example of preparing a cash budget:

Imagine we have a toy car company that has been expanding rapidly. With several new machinery purchases coming up, we’ve decided to prepare a cash budget to help manage the company’s cash flow. Here is the budgeted data for the 6-month period to August:

March April May June July Aug £000 £000 £000 £000 £000 £000

Credit sales 500 500 500 540 540 560 Cash sales 70 81 88 92 93 97 Wages 200 200 200 220 220 220 Credit purchases 140 145 155 160 170 170 Operating costs 120 122 125 128 131 136 (excl. depreciation)

Additional information:

Credit customers are expected to pay as follows: 75% in the month following sale, 15% in the second month, 6% in the third month, and 4% written off as bad debts.

60% of wages are paid in the month they are incurred, with the remaining 40% paid the following month.

80% of credit purchases are paid for in the month after purchase, with the remaining 20% paid two months after purchase.

Operating costs are paid in full each month.

The company recently sold an old piece of machinery for £85,000, for which full payment is expected in June.

The company has just purchased 3 new machines, each for £140,000. The first machine must be paid for in full by June, while the other 2 must be paid for by July.

The opening cash balance on March 1 is £81,000

Budgeting Techniques

In order to prepare our cash budget, we will go through the following process:

Step 1: Calculate cash receipts

Cash sales

From the budgeted data above, we know that our cash sales will be as follows:

June £92,000 July £93,000 August £97,000

Credit sales

We need to calculate our receipts from our credit sales based on the following model:

1 month after sale 75% 2 months after sale 15% 3 months after sale 6% Bad debts 4%

We can summarise these receipts as follows:

Receipts Credit sales June July Aug £000 £000 £000 £000

March 500 30 April 500 75 30 May 500 375 75 30 June 540 405 81 July 540 405 480 510 516

The above chart shows that in June, we will collect 6% of March’s sales (£30,000), 15% of April’s sales (£75,000) and 75% of May’s sales (£375,000) for a total of £480,000 in cash receipts. The same collection pattern is applied to both July and August.

Other receipts

We forecast that we will receive £85,000 in payment for our machinery in June.

Budgeting Techniques

Summarise cash receipts

We’re now able to summarise all cash receipts for June-August:

June July Aug £000 £000 £000 Cash sales 92 93 97 Receipts from credit sales 480 510 516 Receipts from machinery sale 85 Total receipts 657 603 613

Step 2: Calculate cash payments

Credit purchases

We know that 80% of credit purchases are paid in the month following purchase, with the remaining 20% paid two months following purchase. Therefore, we can summarise payments for purchases as follows:

Payments

Purchases June July August £000 £000 £000 £000 April 145 29 May 155 124 31 June 160 128 32 July 170 136 153 159 168

The above chart shows that in June, we will pay for 80% of May’s purchases (£124,000) and 20% of April’s purchases (£29,000) for a total of £153,000. The same pattern is applied to July and August.

Wages

We know that wages are paid 60% in the month they relate to and 40% the following month:

Budgeting Techniques

Payments

Wages June July August £000 £000 £000 £000 May 200 80 June 220 132 88 July 220 132 88 August 220 132 212 220 220

Operating costs

Operating costs are paid in full each month. For June to August this amounts to:

June £128,000 July £131,000 August £136,000

Capital expenditure

Lastly, we need to account for our new machinery payments. One machine is being paid for in June, which amounts to £140,000. In July, two more machines are paid for, which cost £280,000 in total.

Summarise cash payments

We can now summarise our cash payments for June to August as follows:

June July Aug £000 £000 £000

Payment for purchases (153) (159) (168) Wages (212) (220) (220) Operating costs (128) (131) (136) Payments for new machinery (140) (280) Total payments (633) (790) (524)

Step 3: Prepare cash budget

Putting our cash receipts and cash payments forecasts together, our cash budget will appear something like this:

Budgeting Techniques

Receipts from cash sales Receipts from credit sales Receipts from machinery sale Total receipts

Payment for purchases Wages Operating costs Payments for new machinery Total payments

Opening cash balance Net cash movement Closing cash balance

June July Aug £000 £000 £000

92 93 97 480 510 516 85

657 603 613

(153) (159) (168) (212) (220) (220) (128) (131) (136) (140) (280) (633) (790) (524)

81 105 (82) 24 (187) 89 105 (82) 7

Step 4: Cash management

In the above example, we see that although a positive cash position is expected by the end of August, there will be a negative cash balance during the month of July. This is largely due to the payments for the new machinery that are due that month. In this situation, the issue becomes how to manage this cash deficit and look for ways to minimise it or avoid it completely.

Some options available would be:

Budgeting Techniques

Factoring or invoice discounting

At our current collection rates, it takes us 3 months to fully cash up each of our debtors. That’s a long time to have cash tied up in receivables. With a factoring or invoice discounting arrangement in place we could typically cash in 80% of our debtors instantly, significantly improving our cash position.

Delaying large items of capital expenditure

During July we’re expecting a cash outflow of £280,000 for new machinery. That’s a big cash commitment for a single month. If we could negotiate just a one-month delay on at least a portion of this payment it would go a long way towards improving our cash position. If we could go one step further and negotiate payment by instalments that would be even better.

Delaying payments to creditors

Good cash management is often about speeding up receipts while delaying payments as much as possible. In this situation, we pay around £160,000 to creditors each month, so delaying a portion of this could go a long way towards keeping us out of overdraft during July. However, care must be taken to not damage supplier relationships in the process.

Overdraft

Short term overdrafts are common, and many businesses will already have these in place with their banks. However, in this example we are looking at a negative £82,000 cash balance in July, which, depending on the business in question can be a rather high limit to secure.

Long term finance

Cash requirements that fall beyond the remedy of an overdraft can be met by obtaining long term finance. Common examples of this are a long-term bank loan or issuing new capital.