Budgeting And Budgetary Control (Copy)

Budgeting and Budgetary Control

1. Introduction to Budgeting

• Budgeting is the process of planning future financial activities within a business.
• A budget is a plan expressed in financial terms that forecasts revenues, expenses, and expected profits.
• The budgeting process allows organizations to:
  • Plan operations systematically.
  • Control and monitor financial performance.
  • Motivate employees by setting financial targets.
  • Aid in decision-making through financial forecasting.
• Different types of organizations, including governments and businesses, use budgets as financial control tools.
• Example:
  • If a business has current sales of $100,000 and expects a 10% annual increase, the budgeted sales for the next year would be:

    Budgeted Sales = 100,000 × 110% = 110,000
    

  • For the following year:

    Budgeted Sales = 110,000 × 110% = 121,000
    

2. Approaches to Budgeting

• Incremental Budgeting:
  • The current budget is based on the previous year’s budget with slight increases (e.g., inflation or cost adjustments).
  • Example: If last year’s salary budget was $50,000, a 5% increase means:

    New Salary Budget = 50,000 × 105% = 52,500
    

  • Disadvantage: Past inefficiencies can be carried forward.
• Zero-Based Budgeting (ZBB):
  • Each new budget starts from scratch and justifies every cost.
  • This ensures all expenses are necessary but can be time-consuming.

3. Key Types of Budgets

1. Sales Budget – Forecasts expected revenue from sales.
2. Production Budget – Plans production levels based on sales expectations.
3. Purchases Budget – Determines material purchases for production.
4. Labour Budget – Estimates workforce needs and associated costs.
5. Expenditure Budget – Covers operational expenses.
6. Trade Receivables Budget – Anticipates future cash inflows from credit sales.
7. Trade Payables Budget – Forecasts cash outflows for supplier payments.
8. Cash Budget – Manages cash flows to ensure liquidity.
9. Master Budget – Consolidates all functional budgets into a comprehensive financial plan.
10. Budgeted Financial Statements – Includes a projected income statement and balance sheet.

4. Limiting Factors in Budgeting

• Some constraints influence budgeting decisions, such as:
  • Demand Limitations – If sales are restricted by market demand.
  • Raw Material Shortages – If suppliers can’t provide enough materials.
  • Labour Shortages – If workforce availability is limited.
  • Financial Constraints – If cash flow issues restrict purchases or investments.
• The order of budget preparation depends on the limiting factor.
  • If sales demand is the limiting factor, the sales budget is prepared first.
  • If production is limited due to materials or labour, the production budget is prioritized.

5. Budgetary Control

• Budgetary control is the process of comparing actual results with budgeted figures to monitor performance.
• The Planning and Control Cycle involves:
  1. Setting budgets based on business objectives.
  2. Implementing and executing planned activities.
  3. Comparing actual performance against the budget.
  4. Taking corrective action when variances arise.

6. Advantages & Disadvantages of Budgeting

Advantages

• Encourages forward planning.
• Increases cost awareness and efficiency.
• Motivates employees when targets are achievable.
• Helps in securing bank loans (lenders evaluate cash budgets).
• Improves coordination between departments.

Disadvantages

• Time-consuming and costly to prepare.
• Budgets may become outdated if conditions change.
• If managers manipulate budgets (budgetary slack), it can reduce efficiency.

7. Behavioural Aspects of Budgeting

• Top-Down Budgeting (imposed by senior management):
  • Ensures consistency with overall strategy.
  • However, managers may feel less ownership and motivation.
• Bottom-Up Budgeting (prepared by department managers):
  • Increases motivation as managers participate in setting targets.
  • But can lead to low-effort targets to ensure easy achievement.
• Ideal Budget: Ambitious yet achievable, involving staff participation.

8. Using Spreadsheets and Software for Budgeting

• Many businesses use Excel spreadsheets or specialized accounting software.
• Advantages of Spreadsheets:
  • Faster calculations and automation.
  • Improved coordination between linked budgets.
• Disadvantages:
  • Requires trained staff.
  • Errors in one spreadsheet can propagate to others.

9. Flexible Budgets

• Fixed Budgets assume constant production levels and may not be useful if output changes.
• Flexible Budgets adjust based on actual activity levels.
• Example: A business prepares a budget based on 20,000 units but actually produces 28,000 units. The flexible budget scales revenue and variable costs accordingly.

Flexible Revenue = Budgeted Revenue × (Actual Units / Budgeted Units)

10. Budget Variances & Performance Evaluation

• Variance Analysis measures differences between actual and budgeted performance.
  • Favourable Variance (F): When actual profit is higher than budgeted.
  • Adverse Variance (A): When actual profit is lower than budgeted.
• Common Causes of Variances:
  • Material price increases.
  • Higher/lower sales than expected.
  • Unexpected wage changes.
• Example of Variance Calculation:

  Sales Variance = (Actual Sales - Budgeted Sales) × Selling Price per Unit
  

• If a manager’s performance is judged based on achieving budgets, they may manipulate the figures (budgetary slack).

11. Master Budget Preparation

• The master budget is a consolidated financial plan including:
  • Budgeted Income Statement: Projects profit/loss.
  • Budgeted Balance Sheet: Forecasts assets, liabilities, and equity.

Example Master Budget Calculation:

1. Sales Budget:

   Sales Revenue = Expected Sales Volume × Selling Price per Unit
   

2. Production Budget:

   Production Units = Sales Units + Desired Closing Inventory - Opening Inventory
   

3. Cash Budget:

   Closing Cash Balance = Opening Cash + Cash Inflows - Cash Outflows
   

12. Exam-Style Questions & Practical Application

• Common budgeting exercises include:
  • Preparing production and purchase budgets based on sales forecasts.
  • Developing a cash flow budget.
  • Conducting variance analysis on budgeted vs. actual results.
• Example Exam Question:
  • Raj Ltd has forecasted sales and expenses over five months and must create:
    1. Production budget.
    2. Purchases budget.
    3. Cash budget.
  • Answer involves step-by-step budget calculations.