1. Understanding and Managing Finance 10
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2. Managing Finance and Budgets
Lecture 10
Budgets (1)

3. 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

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

5. Section A:
What are Budgets?

6. 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)

7. 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.

8. 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.

9. 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.

10. 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

11. 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.

12. 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.

13. 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
Cash Sales
Total
Payments (£000) Jan Feb Mar Apr May Jun
Creditors
Salaries
Electricity
Other overheads
Loan repayments
Total payments
Cash-flow
Opening Balance
Closing Balance

14. 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
Cash Sales
Total
Payments (£000) Jan Feb Mar Apr May Jun
Creditors
Salaries
Electricity
Other overheads
Loan repayments
Total payments
Cash-flow
Opening Balance
Closing Balance

15. 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
Cash Sales
Total
Payments (£000) Jan Feb Mar Apr May Jun
Creditors
Salaries
Electricity
Other overheads
Loan repayments
Total payments
Cash-flow
Opening Balance
Closing Balance

16. 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
Cash Sales
Total
Payments (£000) Jan Feb Mar Apr May Jun
Creditors
Salaries
Electricity
Other overheads
Loan repayments
Total payments
Cash-flow
Opening Balance
Closing Balance

17. 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
Cash Sales
Total
Payments (£000) Jan Feb Mar Apr May Jun
Creditors
Salaries
Electricity
Other overheads
Loan repayments
Total payments
Cash-flow
Opening Balance
Closing Balance

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

19. 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.

20. How are Budgets Created?
Section B:
How are Budgets Created?

21. 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.

22. 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.

23. 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

24. 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”

25. 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.

26. 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

27. 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

28. 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’.

29. 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

30. 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

31. 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.

32. 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.

33. 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.

34. 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

35. 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

36. 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

37. 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.

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

39. 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.

40. 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.

41. Cash Budget - Example Receipts (£000) Jan Feb Mar Apr May Jun
Debtors
Cash Sales
Total
Payments (£000) Jan Feb Mar Apr May Jun
Creditors
Salaries
Electricity
Other overheads
Loan repayments
Total payments
Cash-flow
Opening Balance
Closing Balance

42. May be calculated in units (by product) or in £
Stock Budget - Example
Stock Jan Feb Mar Apr May Jun
Opening Balance
+ Purchases/Production
- Usage
Closing Balance
May be calculated in units (by product) or in £

43. Debtors Budgets - Example
Debtors Jan Feb Mar Apr May Jun
Opening Balance
+ Sales
- Cash received
Closing Balance

44. Creditors Budgets - Example
Creditors Jan Feb Mar Apr May Jun
Opening Balance
+ Purchases
- Payments made
Closing Balance

45. Income & Expenditure Budget - Example
Jan Feb Mar Apr May Jun
Sales
Direct Costs
Materials
Labour
Total Direct Costs
Gross Profit
Overheads
Admin Salaries
Travel
Other costs
Total Overheads
Net Profit (5)
Cumulative (5) (2)

46. Master Budgets - Example
Jan Feb Mar Apr May Jun
Stock
Debtors
Cash
Creditors
Net Working Capital
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.

47. 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
ADD Some Stuff
LESS Other Stuff
Closing Balance
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.

48. 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.

49. 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.

50. 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

51. 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

52. 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)

53. 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

54. 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.

55. 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

56. 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.

57. Section D:
Summary

58. The uses of budgets Five areas of usefulness: Forward planning
Co-ordination
Motivation
Control
Authorisation

59. 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.

60. Follow-Up to Lecture 9 - Activities
M & A Chapter 12 pp , pp , pp
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.