1. The Budgeting Process
January 16th 2007

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. 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. Overview of the planning process

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. 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. 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. Budgets moving up the organisation hierarchy

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

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
Echidna Platypus
Material A 5 kilos 8 kilos
Material B 3 kilos 4 kilos
Labour 6 hours 10 hours

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

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. Sales Budget Product Units sold Unit selling price Total Revenue (£)
Echidna 9, ,150,000
Platypus 6, ,400,000
5,550,000

14. Production Budget Dept 1 (Echidna) Dept 2 (Platypus)
Units to be sold 9,000 6,000
Planned closing inv. 1,
Total units required 10,500 6,700
Less opening inventory
Units to produce 9,700 6,400

15. Direct Materials Usage Budget
Dept 1 Dept 2 Totals
Units Unit Price Total Units Unit Price Total Total Units Cost
   
48,500 £ ,200 51,200 £ ,240 99, ,440 (A)
29,100 £ ,080 25,600 £ ,280 54, ,360 (B)
508, , ,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. Direct Materials Purchases Budget
Material A Material B
Production requirement (DM usage) 99, ,700
Planned closing inventory 1, ,000
101, ,700
Less opening inventory
100, ,100
Planned purchase price £ £8.80
Budgeted Purchases £521,560 £484,880

17. Direct Labour Budget Dept 1 Dept 2
Budgeted production (units) 9,700 6,400
Hours per unit
Total budgeted hours 58,200 64,000
Budgeted wage rate £10.00 £10.00
Total wages £582, £640,000

18. Factory Overhead Budget
Anticipated activity - Department 1 = 58,200 hours
Anticipated activity - Department 2 = 64,000 hours
Dept 1 Dept 2
Controllable overhead * 203, ,000
Non-controllable overhead 290, ,000
Total overhead , ,000
Budgeted departmental overhead rate ** £ £4.34
* 58,200 X £3.50
** 493,700/58,200

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. 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. 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. 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. 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. 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. Stages in ZBB Developing Decision Packages Rank the 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. 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