Managing Finance and Budgets Lecture 9 Budgets (1)

Managing Finance and Budgets

Lecture 9

Budgets (1)

Session 9 – Budgets (1)

LEARNING OUTCOMES To understand the importance and role of budgets in

organisations To understand the processes involved in the setting and

monitoring of budgets

Key Concepts

Budget definitions and purpose The budget-setting process Types of budget

Section A:

What are Budgets?

Budgets - definitions

“A plan, qualified in money terms, prepared and approved prior to a defined period of time, usually showing planned income to be generated and/or expenditure to be incurred

during that period, and the capital to be employed to attain given objectives”

(CIMA definition)

What exactly is a Budget?

A budget:• Predicts the contribution to income which will be expected

to be generated by each department and each project.• Allocates to each department, project or activity an

appropriate share of the of funding in order to enable that income to be generated.

What exactly is Budget for?

A budget:• enables a business to plan appropriately for the future• Important tool for management agenda-setting and

control• sets targets in monetary terms for departments and

projects• provides a way of sharing out resources to departments

and projects so that they can have continued existence.

Example of a Cash Budget

Receipts (£000) Jan Feb Mar Apr May JunDebtors 60 60 55 45 50 50Cash Sales 10 10 5 15 10 10Total 70 70 60 60 60 60Payments (£000) Jan Feb Mar Apr May JunCreditors 30 30 35 25 30 30Salaries 10 10 10 10 10 10Electricity 15 15Other overheads 5 5 5 5 5 5Loan repayments 15 15 15 15 15 15Total payments 60 60 80 55 60 75Cash-flow 10+ 10+ 20- 5+ - 15-Opening Balance 20 30 40 20 25 25Closing Balance 30 40 20 25 25 10

This example budget shows how we set targets, allocate money, make predictions and set targets.

This example budget shows how we set targets, allocate money, make predictions and set targets.



These are predictions about the cash inflow . These will become monthly targets for sales and for debt collection.

These are predictions about the cash inflow . These will become monthly targets for sales and for debt collection.



These are predictions about the cash outflow . Most of these are fixed and will be paid at the times stated.

These are predictions about the cash outflow . Most of these are fixed and will be paid at the times stated.



This is our predicted monthly cash inflow/outflow. We can use this to detect peaks and troughs

This is our predicted monthly cash inflow/outflow. We can use this to detect peaks and troughs



Finally we can monitor the cash balance on a month by month basis. We can predict for example where overdrafts are needed.

Finally we can monitor the cash balance on a month by month basis. We can predict for example where overdrafts are needed.

The uses of budgets

Five areas of usefulness:

Forward planning

Co-ordination

Motivation

Control

Authorisation

Budgets - Purpose

Encouraging forward planning and identifying any possible future problems to enable solutions to be implemented in advance

Ensuring co-ordination across the organisation so that all departments are able to fulfil organisational objectives

Motivating managers to improved performance against set benchmarks

Providing a basis for control systems Providing a basis for a system of authorisation, so that

managers know exactly what are the limits to their authority, manage within them.

Section B:

How are Budgets Created?

How are Budgets created?

The budget-setting process is quite complex, and often very time-consuming.

It involves a number of stages, some of which ask the business to question precisely what it is doing, and where it is going – almost at a ‘philosophical' level

Other stages involve detailed calculations of amounts of money and negotiations about who gets what.

A complex budget may take six months to one year to produce.

Budget Setting

This is often an annual process linked to a review of long-term plans – Planning & Control

It is an iterative process. Tentative plans are created, which are thrown open to discussion. These discussions then lead to modifications and further discussion, and so on until the budget is set.

Should be participative – all interested parties involved, with the process ‘transparent’.

A combination of top-down(i.e. agenda-setting) and bottom-up (i.e. recognition of needs) approaches is required.

1.Identify business objectives

2. Identify available options

5a.Collect information on performance

4. Prepare detailed plans or budgets

3. Evaluate and select options

The Planning & Control Process

5b. Identify and respond to variances

5c. Revise Plans if necessary

1. Identifying Business Objectives

• Business Aims and Objectives are normally encapsulated in a Mission Statement. Such statements often aspire to ideals:• Liverpool Hope University College aspires to: “educate

students in mind, body and spirit”• Railtrack plc has a vision of : “a safe, reliable, efficient

and modern railway”• On the other hand, some companies take an altogether

more pragmatic view.• Cadbury Schweppes plc has a mission statement

committed to: “..growth in shareholder value”

1. Identifying Business Objectives

• Objectives are normally more specific than the aims.• These vary, but will include consideration of such things

as:• The kind of market the business seeks to serve• The market share it aspires to• The level of operating efficiency• The kind of product it offers• The level of growth to be attained• The level of profit required

• These objectives should be quantifiable and be consistent with the Mission statement.

2. Identifying Available Options

• To achieve the business objectives, a number of strategies may be available.

• In order to uncover these, information will need to be collected,

• This process may be time-consuming• The information will include

• an analysis of the external competitive environment, • and an analysis of the internal resources and

capabilities of the business

2. Identifying Available Options

External considerations might include:• Market size, growth• Level of competition• Threat of newcomers• Relative powers of trades unions, interest groups etc.Internal Considerations might include:• Culture within the organisation• Marketing, distribution issues• Manufacturing capability• Finance and administration• Research & Development• Human Resource Management

3. Evaluating and Selecting Options

• During the evaluation phase, Managers must examine the available information on each option to determine which one most closely fits with the objectives that have previously been set.

• NB Research suggests that too much information may produce ‘information overload’, where managers become confused and distracted by irrelevant data.

• Sometimes this is called ‘paralysis by analysis’.

3. Evaluating and Selecting Options

• During the selection phase, the options chosen will form the basis of the long-term plan

• These options will specify things such as:• Products or service to be offered• Sources of finance and the amounts• Capital investments• Personnel requirements

4. Setting the Budget

• A budget is basically a short-term plan (normally one year) which is expressed mainly in financial terms.

• Budgets will normally define precise targets for such things as:• Cash Receipts & Payments• Sales targets for each item or department• Stock requirements• Labour requirements• Production Levels

5a. Collecting Information on Performance

• Control = the process of making planned events actually occur.

• Accounting is very useful in this context. Plans are set in accounting terms, and outcomes can be matched against targets.

• Where differences occur, these are highlighted as variances.

5b. Responding to Information on Performance

• Managers will be alerted to variances between the budgeted amounts and the actual figures.

• Action will be needed in order to get the business on track towards achieving budgets.

• For example if sales targets have not been achieved, the manager may need to review the sales strategy, to discuss alternative forms of marketing or to make concerted efforts to find new customers.

5c. Revising Plans and Budgets

• If variances continue and are not rectified, or figures are produced on the basis of incorrect assumptions, or circumstances alter, then a revised budget may need to be published.

• This new budget will set different targets, and reallocate the remaining funds in order to respond to the new circumstances.

1. Identify key objectives

2. Identify available options

5.Collect information and control

4. Prepare detailed plans or budgets

3. Evaluate and select options

The Planning & Control Process – a summary

Mission, Aims, ObjectivesMarket, Products, Services

Sales, Costs, Profits, Returns

Limiting factors: External & internal Environment - market size, production

capability, competition

Markets, products, financing, physical resources, human resources

Short-term plans: Sales, Cash, Stock,Labour, Production Master budget

Identify variances and respondas appropriate

Activity One

List the advantages and disadvantages of using budgets in an organisation.

Activity One - solution

Advantages• Each are of the business

knows exactly what they need to achieve

• Each manager knows precisely what resources are available to work with

• The business can plan effectively for expansion and be proactive, not reactive.

.

Disadvantages• Targets tend to be met, but

not exceeded

• Resources tend to be ‘used up’, even where they are not required.

• The business finds it hard to respond to new initiatives, since the resources are already set.

Section C:

What are the different types of Budget?

Budgets – Time horizons

Periodic budget This is a one-off budget set for a year (e.g.) It is normally broken down into monthly or weekly

amounts

Continual Budget This will be updated continually (still for one year, but a

new month will be added to replace the one which has passed.)

Budgeting Principles

Incremental budgeting This is a method of budgeting based on what happened

last year, but with alo9owance for factors such as inflation (e.g if spending was £8,000 last year, we might increase it to £8,250 this year.)

Zero-Base Budgeting This rests on the philosophy that all spending needs to be

justified; there can be no ‘carry over’. Managers will need to be convinced that each activity represents ‘value for money’.

Types of budget

Cash budget Stock budget Debtors budget Creditors budget Income & Expenditure budget Capital budget Discretionary budget Master budget

Cash Budget - Example


Stock & Debtors Budgets - Example

Stock Jan Feb Mar Apr May Jun

Opening Balance 0 20 50 40 30 20

+ Purchases/Production 30 60 50 20 20 50

- Usage 10 30 60 30 30 60

Closing Balance 20 50 40 30 20 10

May be calculated in units (by product) or in £

Debtors Jan Feb Mar Apr May Jun


+ Sales 30 60 50 20 20 50

- Cash received 10 30 60 30 30 60


Creditors Budgets - Example

Creditors Jan Feb Mar Apr May Jun


+ Purchases 30 60 50 20 20 50

- Payments made 10 30 60 30 30 60


Income & Expenditure Budget - Example

Jan Feb Mar Apr May JunSales 100 120 150 140 130 120Direct Costs Materials 40 48 60 56 52 48 Labour 20 24 30 28 26 24Total Direct Costs 60 72 90 84 78 72Gross Profit 40 48 60 56 52 48Overheads Admin Salaries 20 20 20 20 20 20 Travel 5 5 5 5 5 5 Other costs 20 20 20 20 20 20Total Overheads 45 45 45 45 45 45Net Profit (5) 3 15 11 7 3 Cumulative (5) (2) 13 24 31 34

Budgeted balance sheet

Sales budget

Budgeted profit and loss

Overheads budget

Cash budget

Purchases budget

Production budget

Frequency of preparation (%)

20 806040 1000

21

35

46

63

73

76

78

Preparation of budgets in SMEs Source: Chittenden, F., Poutziouris, P., and Michaelis, N. Financial

management and working capital practices in UK SMEs, Manchester Business School, 1998

Setting Complex Multiple Budgets

Clearly, where there are a number of interlocking budgets to create, the process can be quite complex.

Often departments are asked to create ‘spending plans’ (speculative, often optimistic documents, bidding for money and suggesting targets)

Managers will be called to interview to justify these plans, and to negotiate realistic targets.

Out of this process, draft budgets will be created, which will be reviewed and co-ordinated.

Finally the master budget will be created and communicated.

Steps in a complex budget setting process

Establish responsibility for the budget-setting process

Prepare the budget for the area of the limiting factor

Prepare draft budgets for all other areas

Communicate the budgets to all interested parties

Communicate budget guidelines to relevant managers

Identify the key or limiting factor

Review and co-ordinate budgets

Prepare the master budgets

Monitor actual performance relative to the budget

Sensitivity Analysis

This is a tool used in setting technically complex budgets: It investigates changes to profit due to adjustments in

key variables It identifies key areas for managers to focus on for

maximum effect

In order to use it, managers need to: Identify key questions to be answered – e.g. what is the

effect on profits of 10% decrease in sales? Or a 10% increase in cost of sales?

Use spreadsheets or other types of computer software in order to create ‘what-if’ analyses.

Thought Activity – Creating a Budget

You have hired a venue to host a touring theatre company for three nights of performances of “Jumpers” by Tom Stoppard. You need to prepare an Income and Expenditure Budget and a Cash Budget for the performances. You need to allow for three income streams: ticket sales; sale of refreshments; and programme sales.

You need to identify key questions you need to ask to enable you to estimate your income, direct costs and indirect costs as accurately as possible.

Having prepared a budget, you need to decide which are the parameters you would like to vary, in order to carry out appropriate sensitivity analysis.

Follow-Up to Lecture Nine - Activities

Preparation: read Chapter 12 Describe key concepts:

Budget definitions and purposes

Budget-setting process

Different types of budget Exercises 12.3 and 12.7

Managing Finance and Budgets Lecture 9 Budgets (1)

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