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1 The Budgeting Process January 16 th 2007. 2 Lecture Objectives Explain how budgeting fits into the overall framework of decision-making, planning and.

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Presentation on theme: "1 The Budgeting Process January 16 th 2007. 2 Lecture Objectives Explain how budgeting fits into the overall framework of decision-making, planning and."— Presentation transcript:

1 1 The Budgeting Process January 16 th 2007

2 2 Lecture Objectives Explain how budgeting fits into the overall framework of decision-making, planning and control Describe the purposes and uses of budgets in organisations Identify the various stages in the traditional budgeting process Describe some of the benefits of effective budgeting and assess some of the limitations of budgeting Construct cash budgets from relevant data

3 3 Overview of the planning process Identify the objectives of the organization. Identify potential strategies. Evaluate alternative strategic options. Select course of action. Implement the long-term plan in the form of the annual budget. Monitor actual results. Respond to divergencies from plan.

4 4 Overview of the planning process

5 5 Why do we produce budgets? To aid the planning of actual operations: –by forcing managers to consider how conditions might change and what steps should be taken now. –by encouraging managers to consider problems before they arise. To co-ordinate the activities of the organization: –by compelling managers to examine relationships between their own operation and those of other departments. To communicate plans to various responsibility centre managers: –everyone in the organization should have a clear understanding of the part they are expected to play in achieving the annual budget. –by ensuring appropriate individuals are made accountable for implementing the budget.

6 6 Why do we produce budgets? To motivate managers to strive to achieve the budget goals: –by focusing on participation –by providing a challenge/target. To control activities: –by comparison of actual with budget (attention directing/management by exception). To evaluate the performance of managers: –by providing a means of informing managers of how well they are performing in meeting targets they have previously set.

7 7 Stages in the budgeting process Communicate details of budget policy and guidelines to those people responsible for preparing the budget. Determine the factor that restricts output. Preparation of the sales budget. Initial preparation of budgets. Negotiation of budgets with higher management. Co-ordination and review of budgets. Final acceptance of budgets. Ongoing review of the budgets.

8 8 Budgets moving up the organisation hierarchy

9 9 The Integrated Process Primary budget drives all others Planned increase in sales affects –production –purchases –labour –cost of overheads –financing/cash

10 10 An Example - Scenario Marsupial Ltd manufactures 2 products - the Echidna and the Platypus. The Echidna is manufactured in Department 1 and the Platypus in Department The products consume 2 materials - A and B, and also direct labour Details of standard costs and usage are given below: Standard costs per unit Material A - £5.20 per kilo Material B - £8.80 per kilo Direct labour - £10.00 per hour Overhead recovery is on the basis of direct labour hours. Standard usage of materials and labour per unit of product EchidnaPlatypus Material A5 kilos8 kilos Material B3 kilos4 kilos Labour6 hours10 hours

11 11 An Example - Scenario Other data: Echidna Platypus Forecast sales 9,000 6,000 Selling price per unit £350 £400 Budgeted closing inventory 1, Budgeted opening inventory Direct Materials Inventories Material AMaterial B Budgeted opening inventory (kgs) Budgeted closing inventory (kgs)1,300 1,000 Budgeted Overheads Dept 1Dept 2 Variable (controllable) £ Fixed (non-controllable) £290,000150,000

12 12 Required Draw up the following budgets… Sales Budget Production Budget Direct Materials Usage Budget Direct Materials Purchases Budget Direct Labour Budget Factory Overhead Budget

13 13 Sales Budget ProductUnits soldUnit selling priceTotal Revenue (£) Echidna9, ,150,000 Platypus6, ,400,000 5,550,000

14 14 Production Budget Dept 1 (Echidna)Dept 2 (Platypus) Units to be sold9,0006,000 Planned closing inv.1, Total units required10,5006,700 Less opening inventory Units to produce9,7006,400

15 15 Direct Materials Usage Budget Dept 1Dept 2Totals UnitsUnit PriceTotalUnitsUnit PriceTotalTotal UnitsCost 48,500£ ,20051,200£ ,24099,700518,440 (A) 29,100£ ,08025,600£ ,28054,700481,360 (B) 508,280491,520999,800 Material A is first Material B is second Total Units calculated as: Production budget X Kilos per unit = 9,700 X 5 = 48,500

16 16 Direct Materials Purchases Budget Material AMaterial B Production requirement (DM usage)99,70054,700 Planned closing inventory 1,300 1, ,00055,700 Less opening inventory ,30055,100 Planned purchase price £5.20 £8.80 Budgeted Purchases£521,560£484,880

17 17 Direct Labour Budget Dept 1Dept 2 Budgeted production (units)9,7006,400 Hours per unit 6 10 Total budgeted hours58,20064,000 Budgeted wage rate£10.00£10.00 Total wages £582,000 £640,000

18 18 Factory Overhead Budget Anticipated activity - Department 1 = 58,200 hours Anticipated activity - Department 2 = 64,000 hours Dept 1Dept 2 Controllable overhead * 203,700128,000 Non-controllable overhead290,000150,000 Total overhead493,700278,000 Budgeted departmental overhead rate **£8.48 £4.34 * 58,200 X £3.50 ** 493,700/58,200

19 19 The Cash Budget Will Deal with Cash Budget as separate entity See Drury for cash budget link to integrated example Illustration – Alf Smith Example

20 20 Does Budgeting work? Bourne et al. (Lore Reform – 2002) suggest some main criticisms of planning and budgeting. Among these such criticisms as –major barrier to responsiveness –rarely strategically focussed –encourage gaming –based on unsupported assumptions –make people feel undervalued Point to the theory of the budget being lost in practice

21 21 The impact of incremental budgeting Early (& simplistic) principle that says Budget concerned with increment in operations in coming budget period Therefore adjust/inflate previous budget in line with known/anticipated price rises But much base-level activity does not change Perpetuates past inefficiencies/errors

22 22 Activity-based budgeting (ABB) Conventional budgeting is inappropriate for those activities where the consumption of resources does not vary proportionately with the volume of the final output of products or services. For support activities conventional incremental budgets merely serve as authorization levels for certain levels of spending. Incremental budgeting results in the cost of non-unit level activities becoming fixed. ABB aims to authorize only the supply of those resources that are needed to perform activities required to meet budgeted production and sales volumes. The ABB process is the reverse of the ABC process: –Budgeted output of cost objects… –Determine the necessary activities… –Determine the resources required for the budget period

23 23 Stages in Activity Based Budgeting Estimate the production and sales volume by individual products and customers Estimate the demand for organizational activities Determine the resources that are required to perform organizational activities Estimate for each resource the quantity that must be supplied to meet the demand Take action to adjust the capacity of resources to match the projected supply Periodically actual results should be compared with an adjusted (flexible) budget

24 24 Zero Based Budgeting (ZBB) Zero Based Budgeting (ZBB) is an approach to budgeting that starts from the premise that no costs or activities should be factored into the plans for the coming budget period, just because they figured in the costs or activities for the current or previous periods. Rather, everything that is to be included in the budget must be considered and justified.

25 25 Stages in ZBB Developing Decision Packages –The decision package is a term associated with ZBB, and refers to an analysis of each discrete activity, according to cost and purpose. –The analysis should also extend to considering the benefits of the activity, alternative courses of action, how to measure performance, and the consequences of not performing the activity. Rank the Decision Packages Allocate Resources –Rank of DPs feed into prioritisation of Resource allocation

26 26 Pros & Cons of ZBB Pros –Questions accepted beliefs –Focuses on value for money –Clear links between budgets and objectives –Involves operational managers actively, and can lead to better communication and consensus –Is an adaptive approach to changing circumstances –Can lead to better resource allocation Cons –Adds to the time and effort involved in budgeting –May be difficulties in identifying suitable performance measures and decision criteria –Questioning current practice can be seen as threatening – careful management of the people element is essential –May be uncertainty about costs and resources of options other than current practice

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