Budgets

On completing this chapter, we will be able to: Understand why financial planning is important. Analyse the advantage of setting budgets- or financial plan. Examine the importance of a system of delegated budgeting. Analyse potential limitations of budgeting. Use variance analysis to assess adverse and favorable variances from budgets.

Introduction: We should plan for our future finances to some degree. Long term: Educational cost, income earnings, Retirement cost etc. Short term: money to spend in the weekend. The above types of planning should be applied in businesses and organisations too. This process is known as Budgeting (process of creating a plan to spend money). And, a Budget is a detailed, financial plan for a future time period.

Advantages of setting budgets Planning for the future must take into account the financial needs and likely consequences of these plans. Setting budgets and establishing financial plans for the future have following advantages. Planning – realistic targets can be set Effective allocation of resource Setting targets to be achieved Co-ordination Monitoring and controlling Assessing performance Modifying

Key features of budgeting Budget is not a forecast, but a plan that organisations aim to fulfill. Budget can be established for any part of the organisation as long as the outcome of its operation is quantifiable. For eg, sales budget, capital expenditure budgets etc. Coordination between departments when establishing budget is essential. Decisions regarding budgets should be made with the subordinate managers who will be involved in putting them to effect. Budget will be used to review the performance of a department and the managers of that dept. respectively.

Stages in preparing budgets Stage 1- Establishing most important organisational objective. -based on previous performance. -external environment. -sales forecast based on research and past data. Stage 2- budget on key factor that is most likely to meet the goal or influence the growth of the business must be first prepared. (for most businesses, sales is a key factor) -care and accuracy is essential as error in the key factor budget will distort all other budgets. Stage 3- Sales budget is prepared after discussion with sales managers in all branches and divisions. Stage 4- Subsidiary budgets are prepared, based on the plans contained in the sales budget. E.g. cash budget, labour cost budget, material-cost budget etc.

Stage 5- Subsidiary budgets are coordinated to ensure consistency. i.e., these budgets do not conflict with each other and planned spending level does not exceed the resources of business. Stage 6- Master budget is prepared containing main details of all other budgets and concludes with budgeted profit and loss account and balance sheet. Stage 7- Master budget is submitted to the board for directors’ approval.

Setting Budgets An organization can choose several different budgeting methods to support organization achieve the best possible results regarding the fiscal management of the organization. Most widely used budget method are :- Incremental budgeting Zero budgeting Flexible budgeting

Incremental Budgeting Incremental budgeting represents a simple form of budgeting that an organization can implement. The budget used for the current fiscal year becomes the base for incremental distribution for the next fiscal year. This type of budgeting assumes that the entire organization and all of its departments will continue to operate at a minimum with the same budget used the previous year. Incremental budgeting works best in organizations in which management does not conduct an extensive analysis of the budget on an annual basis and there is little fluctuation.

Zero Budgeting Budgeting method that involves starting with $0 and adding only enough money in the budget to cover expected costs. In zero-based budgeting, each individual outlay is carefully scrutinized and justified. Expenses are not assumed just because they took place in a prior year or a prior budget, they must instead be demonstrated as necessary on a per-item basis. Each spending item also is considered in light of potential alternatives, and priorities are developed for choosing between different alternative proposals.

Flexible Budgeting A flexible budget is a budget that adjusts for changes in the volume of activity. The flexible budget is more sophisticated and useful than a fixed budget, which remains at one amount regardless of the volume of activity. Variance along with the efficiency problems is indicated in flexible budgeting. That is, it indicates materials are seem to be used less efficiently. Fixed BudgetActual LevelFlexible Budget Output100 units80 units Direct Materials$20000$18000$16000

Potential Limitations of Budgeting Lack of flexibility Focused on short term May lead to unnecessary spending Training needs must be met Setting budgets for new projects

Budgetary Control- variance analysis The process of comparing the actual performance of the organisation with the original targets (covered by budget), and investigating the differences is known as variance analysis. Variance is the difference between budgeted and actual figures. Importance of analysing the variance: Measures differences from the planned performance of each dept. It assists in analysing the causes of deviations from budget. An understanding of deviations can be used to change future budgets to make them more accurate.

Responding to variance analysis results Managers may need to respond quickly to the variance. Variance can be adverse and favorable. – Adverse variance- actual performance is worse than the expected results. – Favorable variance- actual performance is better than the expected results.

Budgets and budgetary control – an evaluation Although, exercising budget is time consuming and can become inflexible It still is worthwhile. Why?? Without detailed plans for allocating money and resources of the business, their will be disparity. Without clear sales budget, departments would not know how much to produce or to spend on promotion. Firm or businesses can evaluate how well the business and its department had performed. Without figures to monitor progress, it is difficult to know where the business is and make changes if required. Budget gives a responsibility and a direction.