Understanding and Managing Finance 10 This Presentation is in Self-Study Form To start the presentation: Press F5 (Top Row of Keyboard) Then use the navigation buttons at the foot of each page.

Managing Finance and Budgets Lecture 10 Budgets (1)

Session 10 – Budgets (1) LEARNING OUTCOMES To understand the importance and role of budgets in organisations To know the different types of budgets that might be set in order to Manage Working Capital To understand some of the issues and processes involved in the setting and monitoring of budgets

Menu A : What are Budgets? B : How are Budgets Created? C : What are the Different Types of Budget? D : Summary

Section A: What are Budgets?

Budgets - definitions A budget is defined as a financial plan for the future. “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)

Budgets - intentions Clearly, in planning for the future, a budget will contain an element of forecasting, but a budget is not simply a forecast. A budget will contain financial and other numerical predictions. These are targets, and are ‘statements of intention’ that events will occur as planned in the budget. This implies an element of control; this in turn means that a budget targets need to be monitored closely and managed effectively.

What exactly is 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.

An Example of a Budget In the previous weeks, we have examined how we might wish to manage the cash element of working capital - carefully controlling the the levels of stocks, debtors and creditors. One of the tools for doing this is a Cash Budget, which attempts to plan for the predicted cash inflows and cash outflows of the working capital cycle. This allows us to set cash targets, and ensure that we do not encounter cash flow problems. View Budget Example SAQ 9.1

Controlling the cash balance Budget Intentions Inner limit Outer limit Target cash balance Cash balance (£) Time (days) 2 8 6 4 9 5 3 1 7 11 12 10 The purpose here is to try to ensure that the cash balance is constrained within the limits set.

Creating the Budget – an Example For each month or week, we document: Cash In Receipts Expected from Trade Debtors and Cash Sales Cash Out Planned Payments to Creditors, Salaries & other overheads Net Cash Flow We use these to calculate the net cash inflow or outflow for that period. Cash Balance We then consider the consequences to the cash balance.

Example of a Cash Budget This example budget shows how we set targets, allocate money, make predictions and set targets. Example of a Cash Budget Receipts (£000) Jan Feb Mar Apr May Jun Debtors 60 60 55 45 50 50 Cash Sales 10 10 5 15 10 10 Total 70 70 60 60 60 60 Payments (£000) Jan Feb Mar Apr May Jun Creditors 30 30 35 25 30 30 Salaries 10 10 10 10 10 10 Electricity 15 15 Other overheads 5 5 5 5 5 5 Loan repayments 15 15 15 15 15 15 Total payments 60 60 80 55 60 75 Cash-flow 10+ 10+ 20- 5+ - 15- Opening Balance 20 30 40 20 25 25 Closing Balance 30 40 20 25 25 10

Example of a Cash Budget These are predictions about the cash inflow . These will become monthly targets for sales and for debt collection. Example of a Cash Budget Receipts (£000) Jan Feb Mar Apr May Jun Debtors 60 60 55 45 50 50 Cash Sales 10 10 5 15 10 10 Total 70 70 60 60 60 60 Payments (£000) Jan Feb Mar Apr May Jun Creditors 30 30 35 25 30 30 Salaries 10 10 10 10 10 10 Electricity 15 15 Other overheads 5 5 5 5 5 5 Loan repayments 15 15 15 15 15 15 Total payments 60 60 80 55 60 75 Cash-flow 10+ 10+ 20- 5+ - 15- Opening Balance 20 30 40 20 25 25 Closing Balance 30 40 20 25 25 10

Example of a Cash Budget These are predictions about the cash outflow . Most of these are fixed and will be paid at the times stated. Example of a Cash Budget Receipts (£000) Jan Feb Mar Apr May Jun Debtors 60 60 55 45 50 50 Cash Sales 10 10 5 15 10 10 Total 70 70 60 60 60 60 Payments (£000) Jan Feb Mar Apr May Jun Creditors 30 30 35 25 30 30 Salaries 10 10 10 10 10 10 Electricity 15 15 Other overheads 5 5 5 5 5 5 Loan repayments 15 15 15 15 15 15 Total payments 60 60 80 55 60 75 Cash-flow 10+ 10+ 20- 5+ - 15- Opening Balance 20 30 40 20 25 25 Closing Balance 30 40 20 25 25 10

Example of a Cash Budget This is our predicted monthly net cash inflow/outflow. We can use this to detect peaks and troughs. These are targets. Example of a Cash Budget Receipts (£000) Jan Feb Mar Apr May Jun Debtors 60 60 55 45 50 50 Cash Sales 10 10 5 15 10 10 Total 70 70 60 60 60 60 Payments (£000) Jan Feb Mar Apr May Jun Creditors 30 30 35 25 30 30 Salaries 10 10 10 10 10 10 Electricity 15 15 Other overheads 5 5 5 5 5 5 Loan repayments 15 15 15 15 15 15 Total payments 60 60 80 55 60 75 Cash-flow 10+ 10+ 20- 5+ - 15- Opening Balance 20 30 40 20 25 25 Closing Balance 30 40 20 25 25 10

Example of a Cash Budget Finally we can monitor the cash balance on a month by month basis. We can predict for example where overdrafts are needed. Example of a Cash Budget Receipts (£000) Jan Feb Mar Apr May Jun Debtors 60 60 55 45 50 50 Cash Sales 10 10 5 15 10 10 Total 70 70 60 60 60 60 Payments (£000) Jan Feb Mar Apr May Jun Creditors 30 30 35 25 30 30 Salaries 10 10 10 10 10 10 Electricity 15 15 Other overheads 5 5 5 5 5 5 Loan repayments 15 15 15 15 15 15 Total payments 60 60 80 55 60 75 Cash-flow 10+ 10+ 20- 5+ - 15- Opening Balance 20 30 40 20 25 25 Closing Balance 30 40 20 25 25 10

SAQ 9.1 Suggest some advantages and disadvantages of using budgets in an organisation. Solution

SAQ1 solution Advantages Each area 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.

How are Budgets Created? 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.

The Planning & Control Process 1.Identify business objectives 2. Identify available options 3. Evaluate and select options 4. Prepare detailed plans or budgets 5a.Collect information on performance 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 had 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 The main aim of budget setting & the entire planning process in general is 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 then 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 targets set within their 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.

The Planning & Control Process – a summary Mission, Aims, Objectives Market, Products, Services Sales, Costs, Profits, Returns 1. Identify key objectives Limiting factors: External & internal Environment - market size, production capability, competition 2. Identify available options 3. Evaluate and select options Markets, products, financing, physical resources, human resources 4. Prepare detailed plans or budgets Short-term plans: Sales, Cash, Stock, Labour, Production à Master budget 5.Collect information and control Identify variances and respond as appropriate

SAQ 9.2 In essence, all that we are doing in a budget is setting targets & allocating money. Why do you think is it necessary to go through such a complex process each year? Why couldn’t we, for example, use last year’s targets with a little it added on for inflation? Solution to 9.2a Solution to 9.2b

SAQ 9.2a Solution We do this because the business conditions will almost certainly have altered since the last time we created a budget. Some factors might include: Economic Climate – good/bad Prices changes (raw materials/finished stock) Competitors New products available Changes to customer needs Changes to production methods

SAQ 9.2b Solution Some budgets are set via this method; this is called ‘incremental budgeting’, and most budgeting would in essence be done by taking last year’s budgets as a starting point. However, because of all the reasons on the previous slide, we cannot take this as the final answer. We need to respond to new conditions, set new targets, and that means reducing some budgets and increasing others.

What are the different types of Budget? Section C: What are the different types of Budget?

How many budgets? So far, the impression might have been that a single budget will be produced, which covers the entire business. This, in some respects is true, and such budgets are called master budgets. However, in reality, there are many budgets produced in the budgeting process. Each area of business, and each department will, in all likelihood have its own budgets with predictions and targets. Master Budgets summarise all of these into Profit & Loss, Balance Sheet budgets.

Types of budget Cash budget Stock budget Debtors budget Here are some examples of the different types of budgets that might be employed in a business: Cash budget Stock budget Debtors budget Creditors budget Income & Expenditure Budget Master budget Please note that the examples are illustrative only, and may not be ‘consistent with one another.

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

May be calculated in units (by product) or in £ Stock Budget - 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 Budgets - Example Debtors Jan Feb Mar Apr May Jun Opening Balance 0 20 50 40 30 20 + Sales 30 60 50 20 20 50 - Cash received 10 30 60 30 30 60 Closing Balance 20 50 40 30 20 10

Creditors Budgets - Example Creditors Jan Feb Mar Apr May Jun Opening Balance 0 20 50 40 30 20 + Purchases 30 60 50 20 20 50 - Payments made 10 30 60 30 30 60 Closing Balance 20 50 40 30 20 10

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

Master Budgets - Example Jan Feb Mar Apr May Jun Stock 30 50 40 30 40 20 Debtors 20 30 60 70 20 10 Cash 40 60 10 -30 -20 70 Creditors 20 50 40 50 40 30 Net Working Capital 70 90 70 20 0 70 Normally a master budget is the one which ties the others together, or summarises them in some way. Here we have just summarised the level of working capital.

Overall Format for a Budget You may have noticed that in the previous examples, almost all the budgets were designed more or less to the same format Budget X Jan Feb Mar Apr May Jun Opening Balance 0 20 50 40 30 20 ADD Some Stuff 30 60 50 20 20 50 LESS Other Stuff 10 30 60 30 30 60 Closing Balance 20 50 40 30 20 10 We might break down the ‘stuff’ into sub-headings, and have separate targets for these, but essentially that is all there is to a budget.

What budgets are actually used in practice? The actual budgets that will be used by different businesses will clearly depend on the business. High street retailers will normally have little use for a ‘Trade Debtors’ budget, but will be very concerned with a Stock Budget and Trade Creditors, especially (as is generally the case) their business is seasonal. A manufacturing company such as Jaguar will have a production budget, where the number of vehicles produced will be planned; however this type of budget would be completely pointless for the Cats Protection League, who might a ‘donations and endowments’ budget, which would be equally irrelevant to Jaguar.

Complex Multiple Budgets The next slide shows how various budgets might be linked together. From the chart, you will see that some budgets depend on other budgets, whereas some are ‘independent’ In addition there will be certain ‘key’ budgets (normally sales) which will drive all other budgets. Clearly, where there are a number of interlocking budgets to create, the budget-setting process can be quite complex.

The Interrelationship of Budgets Trade Debtors budget Cash budget Trade Creditors budget Overheads budget Capital Expenditure budget Direct Labour budget Raw Materials purchases budget Sales budget Trade Creditors budget Production Budget Raw materials Stock Budget

Setting Complex Multiple Budgets 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. Next week we will examine more closely the budget-setting process, and what is done, and in which order. SAQ 9.4

SAQ 9.4 Working Capital Budgets 1. In terms of managing Working Capital on a week-by-week (or possibly month-by-month) basis, what budgets do you think it might be important to create? 2. Could you list these in order of importance? 3. Examine this slide which shows the results of a survey of the Working Capital Budgeting practices of UK SMEs. Do the results of this agree with what you had suggested? Solution to 9.4(1) Solution to 9.4(2) Solution to 9.4(3)

Preparation of budgets in SMEs Source: Chittenden, F. , Poutziouris, P 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 Budgeted balance sheet Sales budget Budgeted profit and loss Overheads budget Cash budget Purchases budget Production budget Frequency of preparation (%) 20 80 60 40 100 21 35 46 63 73 76 78

SAQ 9.4(1) Working Capital Budgets Some Comments It is probably important to create a Sales Budget, which is subdivided into Cash and Debtors. It is also important to budget for Purchases; again these might be subdivided into Cash and Credit. There might be a separate Cash budget which summarises cash movements, and most companies would expect to work towards some sort of budgeted Profit & Loss Account.

SAQ 9.4 (2) Working Capital Budgets Some Comments We might reasonably expect: Cash Budget Sales Budget (Cash + Trade Debtors) Purchases Budget (Cash + trade Creditors) Stock Budget (could be summary of Sales + Purchases) Budgeted Profit & Loss

SAQ 9.4 (3) Working Capital Budgets Some Comments A large majority of UK SMEs use both Sales Budgets & Budgeted Profit & Loss Accounts. This would suggest that their focus is on the sales & marketing end, with an eye on profitability. This is important, but not the overriding factor. Unless we monitor other activities it may be difficult to actually improve profitability. Cash Budgets are clearly important, with 63% of SMEs adopting them; however, it is interesting to note that almost 40% of SMEs do not appear to monitor their cash flow through a budget. Without a clear budget provision, cash flow problems can overtake a business. Purchases seem to have low priority. This would make monitoring and controlling stock levels very difficult.

Section D: Summary

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.

Follow-Up to Lecture 9 - Activities M & A Chapter 12 pp 355-360, pp360-363, pp 371-376 You should ensure that you attempt both the MCQs and the ‘fill in the blanks’ questions on the M & A website. Questions like these will be part of the exam. The Seminar this week will not concern budgets, but will be Test 3 on Ratios & Working Capital, together with a short introduction to the Sample Case Study.