Week 7 Budgeting Readings: Chapter 9

1. Week 7 Budgeting Readings: Chapter 9

2. Learning Objectives Describe the link between strategic planning and budgeting Explain the importance of budgeting in an entity’s planning List the key steps in the budgeting process Identify the different types of budgets Outline the components of a master budget

3. Learning Objectives Prepare a schedule of cash receipts from debtors Prepare the different types of budgets Discuss the behavioural issues associated with budgeting

4. Budgeting and Strategic Planning Strategic planning concerns longer term planning (typically 3-5 years) It is usually carried out by senior management It commonly relates to broader issues such as business takeovers, expansion plans, deletion of business segments, and radical product/service development

5. Budgeting and Strategic Planning (cont) Budgeting is a process that focuses on the short term (usually maximum of 12 months) A budget is the quantitative expression of an entity’s plans Budgets operationalise strategic plans and allow operational areas to understand how their area contributes to the entity’s strategic objectives

6. Budgets • Entities engage in a planning process that requires involvement in a budgeting process • Part of the formal planning process relates to an entity’s operational plans, including short term goals and targets • Performance management involves setting targets in other than just financial terms e.g. improving customer service, corporate governance, management techniques, and human resource management

7. Budgets (cont) • Budgeting can assist in decision making by: • putting into operation longer term plans • setting targets for managers • identifying resource constraints in budget period • identifying periods of expected cash shortages and excess cash holdings • assisting with short-term planning decisions, such as capacity utilisation

8. Budgets (cont) • providing profit forecasts and other financial data to the capital markets • forecasting data such as sales or fees, which commonly set the level of activity for the budget period • helping determine required inventory levels and purchasing requirements for raw materials • planning labour and other inputs • determining the ability of the entity to meet financing commitments

9. The Budgeting Process Consideration of past performance Assessment of expected trading and operating conditions Preparation of initial budget estimates Adjustment to estimates based on communication with, and feedback from, managers Preparation of budgeted reports and sub-budgets Monitoring of actual performance against the budget over the budget period Making any necessary adjustments to the budget during the budget period

10. The Budgeting Process (cont) Throughout the process communication with managers who are affected by the budgets should occur There is a need for those within the entity to work together to develop the plan for the coming year The interaction of the various personnel enable them to understand the impact of their decisions and to assess whether value is created for the entity.

11. Types of Budgets Sales (or fees) budget – this is prepared first and sets the expected level of activity for the entity Operating (expenses) budget Production and inventory budgets Purchases budget – sets the required level of purchases based on the sales budget Budgeted income statement – includes budgeted income and budgeted expenses to determine budgeted profit/loss Cash budget – includes budgeted cash receipts and cash payments

12. Types of Budgets (cont) Budgeted balance sheet – budgeted assets and liabilities at the end of the period Capital budgets – budgeted expenditure on non-current assets Manufacturing overhead budget – estimating overheads or expenses associated with production activities

13. Master Budget A master budget is a set of interrelated budgets for a future period which provides a framework for viewing relevant budgets of an entity The master budget links together all the budgets prepared for the period (the budgets are all based on the sales budget as this sets the expected level of activity)

14. Master Budget (cont)

15. Master Budget (cont) • Stages in the preparation of a master budget • Determine the expected level of activity for the coming budgeting period • Developing the sales budget • Developing the production budget • manufacturers only • Developing the materials budget • manufacturers only

16. Master Budget (cont) • Stages in the preparation of a master budget • Developing the purchases budget • Retailers and manufacturers only • Developing the labour budget • service providers do this after the sales budget • Developing the operating expenses budget

17. Variances • Budgets are only estimates and sometimes what actually happens is different from the plan or estimate. This is called a variance. • A variance is a difference between the budgeted amount and the actual result. These differences or variances can either be:

18. Variances (cont) • A favourable variance (‘f’, good) will occur when actual revenues are larger than budgeted, or actual costs are lower than budgeted. This is a positive outcome. • An unfavourable variance (‘u’, bad) will arise when the actual revenue is less than budgeted, or actual costs are greater than budgeted.This is a negative outcome.

19. Activity 7.1 Digby Ltd makes specially designed coffee cups. The entity has recently implemented a new marketing strategy. Unit sales for each quarter of 2011 were as follows:

20. Activity 7.1 Due to the change in sales strategy, the marketing department at Digby Ltd expect unit sales to grow by 10% in the first two quarters of 2012, and by 20% in the second two quarters of 2012. The unit sales price will be the same as in 2011, at $20 per unit. Prepare a sales budget for 2012.

21. The Cash Budget • The cash budget is a statement of expected future cash receipts and payments • It assists decision making by: • documenting timing of all cash receipts and payments • helping to identify periods of expected cash shortages and surpluses • identifying suitable times for purchase of non-current assets

22. The Cash Budget (cont) • assisting with planning and use of borrowed funds • providing a framework for ‘what if’ analysis • For an entity that provides goods or services on credit, one of the main tasks in the preparation of a cash budget is calculating the cash receipts from the credit sales or fees generated • This is commonly shown in a schedule of receipts from debtors/accounts receivable

23. Step 3 : Prepare a schedule of receipts Refer to data on pages 394 and 395 for this example.

24. Activity 7.2 From the following data for Ferris Ltd calculate the receipts from debtors for June, July and August of 2012: Credit sales are normally settled 60% in the month after the sale, and 35% in the second month after the sale. 5% of sales are never collected (they become bad debts).

25. Step 4 prepare the cash budget

26. Activity 7.3 Prepare a cash budget for Ferris Ltd for the quarter ending 31 August 2012. (The cash balance on 1 June 2012 is $11,250). The following info is available for the quarter ending 31 August 2012:

27. Budgets: Planning and Control The preparation of the cash budget is an important part of the planning process It can then be used for monitoring cash performance, also known as the control process A cash budget prepared on a month-by-month basis is much more useful for this purpose than one prepared on a quarterly or yearly basis

28. Budgets: Planning and Control (cont) As each month passes, actual cash numbers can be compared to the budget numbers, with the difference between the two known as a variance

29. Variance Report (example)

30. Improving Cash Flow • Cash inflow may be increased by: • improving the collections of cash from debtors • seeking ways to improve sales or fees • reducing unnecessary stock levels • arranging external finance • providing an extra capital contribution from the owners, or considering a change in ownership structure • selling excess non-current assets

31. Improving Cash Flow (cont) • Cash outflow may be reduced by: • cutting expenses by identifying areas of waste, duplication or inefficiency • making use of creditors’ terms • keeping inventory levels to only what is required, as excess inventory ties up cash and often adds to storage and handling costs • deferring capital expenditures

32. Behavioural Aspects of Budgeting • Like all decision-making processes, budgeting is affected by human behaviour, attitudes and assumptions • These are seen in the management styles adopted in the budget process • In an authoritarian style of budgeting, • senior management simply sets the targets and the budget for unit managers • unit managers have little say in the targets that are set

33. Behavioural Aspects of Budgeting (cont) • In a participative style of budgeting • targets and budgets are arrived at by a process of discussion and negotiation between senior management and unit managers • unit managers are seen to have had a say in the setting of targets and the budget The participative style sounds like a better way to go, but the disadvantage for the senior managers it that it is very time consuming negotiating with lower level managers and utilises a lot of their valuable time.

34. Behavioural Aspects of Budgeting (cont) • The behavioural aspects of budgeting are also seen in the attempts by some line managers to • overstate planned expenditure or understate planned revenue or receipts • include some margin for error in case targets are not met (called “padding the budget”) • manipulate information so that their performance is presented in the best possible light

35. Summary Strategic planning is long term but it influences shorter term aspects of the budgetary planning process A master budget may be viewed as a set of interrelated budgets for a future period A master budget is commonly classified into a set of operating budgets and financial budgets The behavioural aspects of budgeting relate to the human involvement in decision making

36. Tutorial Questions The following questions should be completed from the textbook before the tutorial in week 8: Chapter 9 Questions 9.2, 9.3, 9.8, 9.15, 9.23, 9.24, 9.34, 9.38 pages 401-411