Basics of Budgeting

BUDGETING

Definition : A budget is a quantified expression of the intentions of the management and operates in a fashion that enables attainment of orgainsational goals.

Elements of a Budget

1. It is a comprehensive and co-ordinated plan.

2. It is expressed in financial and physical terms.

3. It is a plan for the company’s operations and resources.

4. It is a future plan for a specified period.

MAJOR OBJECTIVES OF BUDGETING

1. To state the company’s goals.

2. To communicate expectations to all concerned.

3. To provide detailed plan of action for reducing uncertainty.

4. To co-ordinate activities and efforts in such a way so as to maximise resources.

5. Measure for controlling performance.

TYPES OF BUDGETS

Comprehensive Budgeting involves the preparation of a Master

Budget. The three important components of Master Budget are:

i) Operational / Functional Budgets

ii) Financial Budgets

iii) Capital Budgets

ESSENTIALS OF BUDGETING

1. Senior management support

2. Clear and realistic goals

3. Assignment of authority and responsibility

4. Creation of responsibility centres

5. Adaptation of accounting system

6. Full participation

7. Effective communication

8. Budget education

9. Flexibility

Budgeting As a Tool of Management Planning and Control• Communication

• Coordination

• Performance Evaluation

• Motivation

Fundamental Concepts & Techniques Used for Budgetary Control

• Cost benefit analysis including the social cost benefit analysis.

• Contingency approach

• Responsibility accounting based on the technique of variance analysis

• Value analysis for services, systems, cost incurrence etc.

• Application of mathematical models such as PERT, CPM,Transportation & Assignment models, L.P. & Simplex Models, Scrutiny Analysis etc.

bBudgeting Process – A Structured Approach

Formation of Multipurpose Budget Team Definition of Vision/Mission/Objectives Exhaustive analysis of :

- Competitive Environment

- Economic Environment

- Political Environment

- Business SWOT

- New Product Strategies

- Corporate Strategic Initiatives e.g.., New/ Restructured Alliances at Industry and Company level

Continued …

• Agree on Volumes and Price Realisations

• Work on related linkages (at various companies, various business etc. viz., Manufacturing, Logistics, etc.)

• First pass preparation of Income/Capital Employed Statements

• Budget Package Finalisation

Continued …

Continued …

Volumes and Price Realisation determination

• Territywise/Productwise Volume and NRV determination (Net Realisable Value).

• Inputs on Brand Pricing,Product Positioning , Past Product Performance Analysis, Proposed Product Lines from Marketing and Technology Teams.

• Deliberations on the above done by the Budget Team to determine Volumes and Prices Regionwise

Continued …

Continued …

• Zero base build up, other than Fixed Commitments

• Projected Business Growth

• Determination of Sales Regions/ Territories

• Manpower Requirement

• New Product Launches

• Proposed Brand Plans

Continued …

Manufacturing Budget Preparation

CapacityVolumes

Inventory

Production Plan

Import Plan

Operations Cost

Variable

Fixed

Labour

Utilities

Standard Cost of Goods Sold

Fixation of RM/PM Costs

Continued …

Logistics Cost Plan

Determined by the Production Plan, Import Plan and Despatch Plan

Continued …

FUNCTIONAL / OPERATIONAL BUDGETS

1. Sales budget

2. Production / Operations

3. Material Consumption

4. Purchase

5. Labour

6. Overheads

7. Marketing and Selling

8. Administration and Finance

AN OVERVIEW OF BUDGETING PROCESSA PLAN OF OPERATIONS Management’s Goals and Objectives for the year

Formalised in

THE ANNUAL PROFIT PLAN

Wherein Mgmt. Specifies

THE OVERALL INCOME OBJECTIVEDetailed in

SALES BUDGETin Qty/Territory/ Product and Time

Period

OTHER INCOME BUDGETInterest Income / Royalty etc.

Less

THE OVERALL COST & EXPENSE OBJECTIVE detailed in

DISTRIBUTION EXP. BUDGET

By Territory

ADMIN. EXP. BUDGET

By Department

OTHER EXP. BUDGET

Interest Exp. Etc.

PRODUCTION BUDGET

Unites to be produced

All the below are prepared for pre decided time period involved

[PURCHASE BUDGET][DIRECT LABOUR BUDGET]

[FACTORY O/H BUDGET]

The Entire PLAN OF OPERTIONS is finally reflected in

THE FINANCIAL BUDGET Composed of

THE BUDGETED B/SASSETS/ LIABILITIES

OWNER’S EQUITY

SUPPORTING SUB-BUDGETS, CASH BUDGET,

INVENTORY BUDGET, CAPITAL EXP. BUDGET,

OTHERS

TABLE SHOWING VAROUS FACETS OF A BUDGET PROGRAM

Name of Budget

What it shows

Prepared by

Based upon Classification by

1) Sales Budget

2) Production Budget

3) Production Cost Budget

4) Materials & Stores

5) Labour Budget

6) Production Over Heads

Estimated sales of products

Estimated Quantity of Production

Cost of Production

Quantity & Value of Materials needed for (2)

Labour Hours and Cost needed for (2)

Estimated Over Heads expenses for (2)

Sales Manager

Production Manager

Production Manager

Production Manager & Costing Department

Production Manager & Costing Department Production Manager & Costing Department

Historical Analysis Business Conditions Salesman's Report Market Analysis, Special ConditionsSales Budget, Production Capacity, Stock Requirements

Production Budget

Production Budget and Stocks on hand

Production Budget

Production Budget and fixed expenses

Product Territory Customers,Salesmen, Period

Product, Department, Period

Product /Department, Period & Elements of Costs

Item wise (Major)

Category/Skill wise

Expense Wise Department Wise

FLOW CHART OF BUDGETARY CONTROL

Specification of organisational objectives and identification of key factors

Sales Budget

Operations Budget

Budget for Prime Cost & Overhead

Budget for Sell. & Dist. Cost

Cap. Expend.Budget

Cash Budget

AdministrativeCash Budget

Master Budget

Acc. & Resp., Var. analysis Managerial Action

Summary of Steps in Budgetary Control

1) SWOT analysis for deciding objectives2) Preparing a budget statement3) Recording the actual performance4) Periodic comparisons between the budgeted and actual performance,

& finding out the favourable and unfavourable variances5) Finding out the causes grouping these variances 6) Basis the cause grouping these variances as “controllable” and

“uncontrollable”7) Deciding the quantum of reward or penalty for the individual or the

teams for the variances8) Revising the standards to suit the cyclic – environmental and

uncontrollable changes in conditions.9) Go through the steps 2 to 7 again10) Thus the process of budgetary control has to be continuous, flexible

and unbiased

ADVANTAGES OF BUDGETING

1. Forced planning.

2. Co-ordinated operations.

3. Performance evaluation & control.

4. Effective communication.

5. Optimum resource utilisation.

6. Productivity improvement.

7. Profit mindedness.

8. Efficiency.

9. Cost control.

LIMITATION IN USING THE BUDGETING SYSTEM

1. Management judgement.

2. Continuous adaptation.

3. Implementation.

4. Management complacency.

5. Unnecessary detailing.

6. Goal conflict.

7. Evaluation system.

8. Unrealistic targets.

VARIOUS STYLES OF BUDGETING

1. Flexible Budgeting

2. Zero Base Budgeting

3. Activity Based Costing

4. Balanced Score Card

PROFIT PLANNING AND CONTROL Consider the following data:

EXHIBIT I

Sales Rs.

Sales

Variables Cost

Contribution Margin

Fixed Cost

Operating Profit

Financing Costs (@10%)

NPBT

I.T. @ 50%

NPAT

Owners Funds

Borrowed funds

Capital Employed

10,00,000

6,00,000

4,00,000

1,00,000

3,00,000

50,000

2,50,000

1,25,000

1,25,000

5,00,000

5,00,000

10,00,000

EXHIBIT II

[A] OPERATING MANAGEMENT PERFORMANCE: (A) =(a) x (b) x(c) = 75% x 40% x 100% = 30%

= 40%(a) P/V Ratio =Contribution Margin

Sales

= 75%(b) Margin of Safety Ratio =Contribution Margin

Operating Profit

(c) Turnover Ratio = = 100%Capital Employed

Sales

B] FINANCIAL MANAGEMENT PERFORMANCE:

(B) = (d) x (e) = 41% x 200% = 82%

(d) NPAT .

OPERATING PROFIT= 41%

(e) Capital Employed Owner’s Funds

= 200%

[C] OVERALL MANAGEMENT PERFORMANCE:

(A) =(B) = 30% x 82% = Approx 25%

EXHIBIT III

BREAK EVEN ANALYSIS

A 75% Margin of safety indicates if sales fell by 75%, losses will start (as shown hereunder)

Sales (reduced by 75%) 2,50,000

Variable Costs @60% 1,50,000

Contribution Margin 1,00,000

Fixed Costs 1,00,000

PROFIT ZERO .

Thus the sales level of Rs. 2,50,000 is the “NO PROFIT – NO LOSS” point or the BEP which is also defined as:

It is defined in units as under:

BEP =Fixed Costs x Sales

Unit Contribution Margin

BEP =Fixed Costs x Sales

Sales – Variable Costs=

Fixed Cost

P V Ratio

BEP =1,00,000 X 10,00,000

4,00,000= 2,50,000

EXHIBIT IV

SENSITIVITY ANALYSIS OF OPERATING MANAGEMENT PERFORMANCE BASIS BEP

In the existing situation OMP is planed @30% on capital employed. With the help of BEP Analysis we can now check its sensitivity to various factors as under:

1. What should be the sales level to increase the OMP to 40% level?

BEP =Fixed Costs + Desired Profit

PV Ratio

1,00,000 + 4,00,000

40%= 12,50,000=

Computation of operating profit at new sales level:

Sales 12,50,000

Variable Costs (60% of Sales) 7,50,000

Contribution Margin (40% of Sales) 5,00,000

Fixed Costs 1,00,000

Operating Profit 4,00,000

BEP =Fixed Costs + Desired Profit

PV Ratio

1,00,000 + 4,00,000

PV Ratio=10,00,000=

5,00,000

10,00,000=PV Ratio= 50%=

Contribution Margin

Sales=

2. What should be the variable costs level to increase the OMP to 40% level?

Computation of Operating Profit at new variable costs level:-

Sales 10,00,000

Variable Costs 5,00,000

Contribution Margin@ 50% 5,00,000

Fixed Costs 1,00,000

Operating Profit 4,00,000

BEP =Fixed Costs + Desired Profit

PV Ratio

Fixed Cost + 4,00,000

40%=10,00,000=

4,00,000 = Fixed Costs + 4,00,000

Fixed Costs = Zero

3. What should be the fixed costs level to increase the OMP to 40% level?

Computation of Operating Profit at New Fixed Costs Level:

Sales 10,00,000

Variable Costs 6,00,000

Contribution Margin 4,00,000

Fixed Costs Zero .

Operating Profit 4,00,000

VARIOUS STYLES OF BUDGETING

1. Flexible Budgeting

2. Zero Base Budgeting

3. Activity Based Costing

4. Balanced Score Card

Balance Score Card

Origin

• Developed by Robert Kaplan and David Norton

• Communicate Companies’ Objectives, link them to

strategy

• Translates mission and strategy into four perspectives

The Balance Scorecard Perspectives

• Financial

• Customer

• Internal business processes

• Learning and growth

Building a Balanced Score Card

More than a mixture of 15 to 25 financial and non financial measures to reflect the business unit’s strategy by linking outcome and performance measures together.

Core Financial Measures• ROI/Economic value added• Profitability• Revenue growth/mix• Cost reduction productivity

Financial Perspectives

• Is strategy implementation improving the bottom line?

• Shareholder value addition

Steps:

- improve ROI

- reduce cost

- increase revenue

- manage risks etc.

Building a Balanced Score Card ……

Core Customer Measure

• Market share

• Customer acquisition

• Customer retention

• Customer profitability

• Customer satisfaction

Building a Balanced Score Card ……

Core Learning and Growth Measures

• Employee satisfaction

• Employee retention

• Employee productivity

Learning & Growth Perspectives

• Identify infrastructure to create long-term growth and

improvement

• 3 principle sources of learning

- people

- systems

- organizational procedures

• Measurement of employee satisfaction, retention,

training & skills

• Aligning incentives with overall organizational success

factors

Internal Business Process Perspectives

• Identify critical internal processes

• Help to deliver value propositions to attract and retain customers

• Satisfy shareholder expectations of excellent financial returns

- innovation

- operations

- post sales service

Limitations

• Are 4 perspectives sufficient?

• No incorporation of other stakeholders’ interest like

suppliers and the community

Conclusions

• The Balance Score Card is basic tool

• Can be modified & customized according to an

Organization's needs

• An important weapon in every manager’s arsenal

Flexible Budgeting It is a budget which by recognizing the difference between fixed, semi fixed and variable costs, is designed to change in relation to the level of activity attained. It is a budget prepared for a range and is also known as variable budget or a sliding scale budget.

Steps in flexible budgeting:

1. Deciding the range of activity

2. Determine cost behaviour patterns

3. Selecting the activity levels to prepare budgets at those levels

4. Prepare budget at each activity level

Zero Base Budgeting

ZBB is a method of budgeting whereby all activities are

revalued each time a budget is formulated and every item of

expenditure in the budget is fully justified. That is, ZBB

involves starting from scratch or zero.

Implementation of ZBB involves the following :

1. Each activity of the organisation is identified and called a decision package

2. Each decision package must be justified

3. If justified the minimum cost to sustain each decision package is determined

4. Alternatives for decision packages are evaluated

5. Managers rank their decision package in order of priority for resource allocation

6. Resources are allocated to the package

ADVANTAGES OF ZBB

1. Allocation of resources by need and benefit.

2. Identifies and eliminates wastage's and obsolete operations .

3. Best possible methods of performing jobs is ensured.

4. Increased staff involvement which may lead to improved motivation and greater interest in job.

5. It increases communication and co-ordination within the organisation.

6. Managers become more aware of cost inputs which help in identifying priorities.

DISADVANTAGES OF ZBB

1. Substantial Cost & time involved in preparing a large number of decision packages.

2. Managers could develop fear and feel threatened by ZBB.

3. Ranking of packages could result in departmental conflict.

Learning Curves and Non Linear Costs

The learning curve phenomena is based on the concept that costs tend to be non linear.

It is found that the cost of doing most tasks of a repetitive nature decrease as experience at doing these tasks accumulate.

Most experience curves, estimated on actual process, indicate that costs decline 20 to 30 percent each time accumulated experience doubles.

Factors that lead to this long-run decline in costs include:

1. Labour efficiency.

2. New process and improved methods.

3. Product stadardisation.

4. Scale effect.

Activity Based Costing

In Activity based costing (ABC) costs are first traced to activities and then to products. It is a system which focuses on activities performed to produce products . Activities become the focal point of cost accumulation.

ABC involves two primary stages

- Tracing costs to activities

- Tracing activities to products

COST DRIVERS IN ABC

1. Number of receiving orders.

2. Number of purchase orders.

3. Number of dispatch orders.

4. Number of units.

5. Amount of labour cost involved.

6. Number of material handling man hours.

7. Number of direct labour hours.

8. Number of vendors/ suppliers.

9. Number of set up hours.

10. Number of employees.

11. Number of labour transactions.

TRADITIONAL COSTING

OverheadCost

P1

P2

P3

PRODUCT

Stage 1 : Overheads assigned Stage 2 : Overheads assigned to to cost centres/ pools. products using cost

driver rate.

Process / Job 1

Process / Job 2

Process / Job 3

ACTIVITY BASED COSTING

OverheadCost

PRODUCT

Stage 1 : Overheads assigned Stage 2 : Overheads assigned to cost centres / pools. to products using

cost driver rate.

Activity 1

Activity 2

Activity 3

Activity 4

Activity 5

P1

P2

P3

P4

P5

REVENUE MANAGEMENT - TOPLINE

Rule I Price then costs

Intuition In high demand times, increase productive capacity. In periods of low demand, reduce capacity and lower headcount.

Entropic Event:

Demand fluctuations growing in frequency and intensity

R.M.P. I Address short term fluctuations with price, then capacity planning in long run.

Rule II Value management and marketing value based pricing dominates cost based pricing.

When customers dominate – value dominates and they do not care about your costs; you care if cost based price exceeds customer’s value.

Find market acceptable price point.

Move from cost-based pricing to price-based costing.

Intuition Set prices to cover costs and provide an acceptable margin (Cost Based Price: CBP)

Entropic Event: Non-conformist customers determine the price: Marketing provides the choices.

R.M.P. II Move from CBP to PBC Monitor market for both Revenue Management (RM)& Cost Management (CM) for Profit Management (PM)

Rule III Sell to segmented micro-markets and not mass markets

Seek and seize revenue advantage rather than worry about cost disadvantage.

Faster-Better-Cheaper mantra

What is this customer willing to pay for this product at this point in time.

There is no average consumer, thus there can not be an average price.

Intuition Price is set to sell the greatest number of units at the highest possible price in the mass markets.

Entropic Event:

Consumer individualism and amoeba market shatters the myth of mass market.

R.M.P. III Different segments demand different prices. To maximise revenue with competition, prices must vary to meet the price sensitivity of each market segment

Rule IV Save your product for your most valuable customers

“First Come, First Served” do not ensure RM or PM

Makes relevance only when there is shortage

Customers who are paying less are those who come First

Favor the most valuable customers

Intuition Sell products and services on a “First Come, First Served” basis

Entropic Event:

Traditional business practices do not satisfy investor demand for revenue growth.

R.M.P. IV Forecast and understand demand at micro-market levels and save products for the most valuable customers through prioritization.

Rule V Decisions should be based on knowledge and not supposition

Data Information Knowledge Profit

Adopt a RM program of appropriate size and scope

Understand window of opportunity and volatility

Understand intentional/unintentional biases and availability of information bias while forecasting

Intuition Assumptions are and can be made about future consumer behaviour based on intuition and personal observation

Entropic Event:

Non-conformist consumers are continuously fragmenting the market and changing buying behaviour

R.M.P. V Forecast demand at the micro-market level, gain knowledge of subtle changes in consumer behaviour patterns and then optimize on Product/Consumer/Supply or Demand.

Rule VI Exploit and leverage each product’s value cycle.

Maximise value of product in micro-markets over time

Adopt a RM program of appropriate size and scope

Get as much money as possible as soon as possible

Entertainment – Movie business example

Intuition Decisions on product availability and pricing are made based on experience, gut feel, tradition or rule of thumb.

Entropic Event:

Rapidly changing market conditions defy conventional approaches

R.M.P. VI Maximise revenue by understanding the value cycle and optimally timing the availability and price of the product to each micro-market segment.The sales force in the trench should be armed with decision support tools built upon appropriate databases so they can make dynamic decisions at the micro-market level.

Facts Data

Knowledge Information

Wisdom Analysis

Profit Optimization Forecasts

Turn Facts into Profit!

THE CRUX OF BUDGETING