Budgeting


A budget is a quantitative expression of management objectives and a tool used to analyze and describe expected operation to those objectives. A budget is simply a plan before the start of the period. However, at the end of the period, it acts as a control device to help management measure its performance against the budget. Therefore, budgets at the same time are plans, control devices and performance evaluation tool.

The process of converting plans into budgets is called ‘budgeting’. Budgetary control system plans in advance the various functions of a business and continuously compares budgeted figures with actual results so that business as a whole can be controlled.

Purpose of budget

  1. to coordinate the activities of different departments towards a single plan so that each is part of an integral activity
  2. to communicate targets to the managers responsible for achieving them
  3. to establish a system of control by providing clearly defined targets of output, incomes and expenses for each department or section of the organization
  4. to help the management in planning the future policy and annual operations
  5. to motivate managers to achieve the organisation’s goals
  6. to evaluate the performance of managers by comparing the actual results with budgeted targets

Advantages of budgetary control system

  1. Budgets serve as yardsticks against which subsequent actual performance can be compared.
  2. Budgetary control system enhances inter-departmental communication and coordination.
  3. A proper budgetary control system assists in delegation of authority and assignment of responsibility.
  4. It helps identify limiting or key factors.
  5. It coordinates activities across departments.
  6. Budgetary control specifies the resources, revenues, and activities required to carry out the strategic plan for the coming year.
  7. Budgetary control improves resources allocation, because all requests are clarified and justified.
  8. Budgetary control provides a tool for corrective action through reallocation and helps to control costs.

Limitations of budgetary control system

  1. Budgetary control can demotivate employees because of lack of participation.
  2. Budgetary control can cause perceptions of unfairness.
  3. Budgetary control can create competition for resources.
  4. A rigid budgetary control reduces initiative and innovation at lower levels, making it impossible to obtain money for new ideas.
  5. Budget are time consuming and expensive to create and monitor
  6. Budgets could lead to conflict between departments

Flexible Budget

Flexible budget recognises the existences of fixed, variable and semi-fixed / semi variable costs. It considers certain items, which will react to changes in the volume of activity and the budget can be “flexed” to reflect this.

A company sets a budget for a certain level of output. If the actual level of activity is higher or lower than the original estimate. The flexible budget adjusts to changes in activity level by flexing the data of original budget in accordance with the actual level.  

Flexible budget helps in planning by preparing a series of budgets based on different volumes of activity.

Functional Budget

A functional budget also known as departmental budget is one that relates to any of the functions or departments of an organization. Separate budgets for each department help an undertaking to assign responsibility to each departmental manager. These budgets are ultimately used in the preparation of master budgets. The main functional budgets are:

  1. Sales budget
  2. Production budget
  3. Purchases budget
  4. Direct labour budget
  5. Trade receivables budget
  6. Trade payables budget
  7. Expenses budget
  8. Cash budget

Sales Budget

A sales budget predicts customers’ future demands. The sales budget is usually prepared in terms of quantities and then evaluated at budgeted unit prices. Factors to be considered when preparing sales budget

  • Production capacity
  • Historical analysis of sales
  • Level of competition

Example 

Malcolm sales team has budgeted sales at 600 units for the first two months of the year 2020. However in March 2020 it is estimated that monthly demand will fall by 5%. No further change was expected in April.

Malcolm presently sells his product for $20 per unit. In January the selling price is expected to rise by 5% and by $2 In March. No further changes were expected in the budget period.


Sales Budget

Details

Jan

Feb

Mar

Apr

Sales volume (Units)

600

600

570

570

Selling price

21

21

23

23

Sales revenue ($)

12 600

12 600

13 110

13 110


Production Budget

A production budget lays down the units expected to be manufactured during each budgeted period to satisfy budgeted sales and inventory requirements. Factors to be considered when preparing production budget:

  • Sales forecast
  • Budgeted inventory requirements
  • Production capacity

Example

XYZ Manufacturers expects to sell 20 000 units in September 2020. The company expects to increase sales volume by 10% each month on previous month’s sales. Inventory is planned in such a way that inventory at end would represent 25% of next month’s sales. Inventory on 1st September 2020 was 5 000 units.


Production Budget

Details

Sept

Oct

Nov

Dec

Jan

Sales volume (Units)

20 000

22 000

24 200

26 620

29282

Add Closing inventory

5 500

5 050

6 655

7 321


Less Opening inventory

(5 000)

(5 500)

(5 050)

(6 655)


Production (Units)

20 500

22 550

24 805

27 286



Purchases Budget

The purchases budget is prepared after the production budget. It sets forth the units expected to be purchased during each month to satisfy budgeted sales and inventory requirements. The purchasing department is responsible for purchasing the budgeted quantities of materials or finished goods to meet the production or sales requirements.

Example

Bed Limited’s sales (units) for the four months ending 31st August 2020 are budgeted as follows:


May

June

July

Aug

6 600

7 200

7 500

8 000


Additional information:

  • Units are purchased at a standard cost of $20 each.
  • The inventory of goods on 30th April 2020 was 640 units,
  • Inventory at end is maintained at 10% of the units expected to be sold in the following month.


Purchases Budget

Details

May

Jun

Jul

Aug

Sales volume (Units)

6 600

7 200

7 500

8 000

Add Closing inventory

720

750

800


Less Opening inventory

(640)

(720)

(750)


Purchases (Units)

6 680

7 230

7 550


Price per unit

20

20

20


Purchases ($)

133 600

144 600

151 000



Note: The same format is used for purchase of finished goods and raw materials.


Direct Labour Budget

The direct labour budget shows the total labour costs and labour hours needed to produce the units estimated in production budget. The budgeted units of production in the production budgets act as a starting point in calculating labour hours and estimating direct wages.

Example

The following units of production are taken from production budget of John Ltd for the four months ending 30 April 2020


January

February

March

April

7 500

8 000

7 200

7 000


Each unit requires 2 labour hours and it is expected that the average wage rate per hour will be $5.


Direct Labour Budget

Details

Jan

Feb

Mar

Apr

Production (Units)

7 500

8 000

7 200

7 000

Labour hours per unit

2

2

2

2

Direct Labour Hours

15 000

16 000

14 400

14 000

Labour rate per hour

5

5

5

5

Direct Labour ($)

75 000

80 000

72 000

70 000


Trade receivables budget

The trade receivables budget helps estimate the amount owed to the business by its trade receivables at the end of a specific period. Cash sales and transactions relating to cash sales are not included in trade receivables budget.

Example 

The budgeted sales of Unity Traders for the months of September 2019 to January 2020 are available. All sales are on credit basis.


September

October

November

December

January

$ 98 000

$ 120 000

$ 160 000

$ 250 000

$ 104 000


Additional information:

  1. 40% of sales are paid in the month of sales and attract a discount of 5%.
  2. 42% of sales are paid for in the month following the month of sale and attract a discount of 2%.
  3. 18% of credit sales are paid for two month following the month of sale and attract no discount.
  4. Trade receivable at 31 October 2019 were $89 640.


Trade receivables Budget

Details

Nov

Dec

Jan

Trade receivables at start

89 640

117 600

178 800

Add credit sales

160 000

250 000

104 000

Less receipts:




Current month

(60 800)

(95 000)

(39 520)

1 month credit

(49 392)

(65 856)

(102 900)

2 months credit

(17 640)

(21 600)

(28 800)

Less Discount allowed

(4 208)

(6 344)

(4 180)

Less Bad debts




Trade receivables at end

117 600

178 800

107 400


Trade Payables Budget

 This budget helps to estimate the amount owed by the business to its suppliers at the end of a specific period. Cash purchases and related transactions are not included in trade payables budget.

Example

 The following budgeted credit purchases for the months of March 2020 to July 2020 are available.


March

April

May

June

July

$ 68 000

$ 72 000

$ 80 000

$ 92 000

$ 88 000


Additional information:

  1. 20% of purchases are paid in the month and attract a discount of 4%.
  2. 48% of purchases are paid for in the month following the month of purchases and attract a discount of 2.5%.
  3. 32% of purchases are paid for two month following the month of purchases and attract no discount.
  4. Trade payable at 30 June 2020 were $79 360.


Trade payables Budget

Details

May

June

July

Trade payables at start

79 360

87 040

99 200

Add credit purchases

80 000

92 000

88 000

Less payments:




Current month

(15 360)

(17 664)

(16 896)

1 month credit

(33 696)

(37 440)

(43 056)

2 months credit

(21 760)

(23 040)

(25 600)

Less Discount received

(1 504)

(1 696)

(1 808)

Trade receivables at end

87 040

99 200

99 840


Cash Budget

 Cash Budget shows monthly budgeted cash receipts and payments of both capital and revenue nature. A cash budget also determines the expected cash balance of the firm at specific intervals.

Uses of cash budget

  1. It helps to identify short term cash needs which give time to management to take appropriate actions to avoid such problems.
  2. It determines future ability of the business to pay its liabilities early to take benefit of cash discounts.
  3. It helps a business determine customer’s credit time before falling into liquidity problems.
  4. It shows the pattern of future cash flows giving information on cash surpluses, which can be used, or deficits, which have to be funded.

Management Actions


Short term surplus

1

Pay trade payables early to obtain cash discount

2

Bulk purchase to obtain trade discount

3

Short term investment

4

Extend credit to customers to increase sales

Short term deficit

1

Renegotiate overdraft limit

2

Offer cash discount to customers for immediate payments

3

Negotiate longer credit period from suppliers

4

Provide incentives to customers for cash purchase

Long term surplus

1

Make long term investment

2

Expand operations

3

Replace non current assets

4

Repayment of debentures

Long term deficit

1

Issue of shares

2

Take long term loan from bank

3

Sale of surplus non current assets

4

Issue of debentures


Format of cash budget


January

February

March

April

Receipts





Cash Sales

***

***

***

***

Receipts from customers

***

***

***

***

Proceed from disposal of NCA

***

***

***

***

Loan

***

***

***

***

Other receipts

***

***

***

***

Total Receipts (B)

***

***

***

***






Payments





Cash purchases

***

***

***

***

Payment to credit suppliers

***

***

***

***

Expenses

***

***

***

***

Purchase of NCA

***

***

***

***

Repayment of loan / debentures

***

***

***

***

Cash drawings

***

***

***

***

Other payments

***

***

***

***

Total Payments (C )

***

***

***

***






Opening Balance (A)

***

***

***

***

Closing Balance (A + B – C)

***

***

***

***

                                                                                                       

Worked Example – Cash Budget