Stage 1. Setting new budget– this starts the control cycle off and is the original budget set in the manner described later, dependent on the size of the organization.
Stage 2. Defining performance measurements– these are the means by which the budget holder’s performance is going to be measured. Typical performance measures include a set return on capital; a specified sales target or market share; a profit target; keeping costs within budget.
Stage 3. Measuring actual performance – once performance measure- ments have been set then actual performance can be recorded. This is made possible by the use of cost centre numbers (and capital job numbers) when inputting financial transactions to the financial database.
Stage 4. Comparing actual with budget – measuring actual performance is insufficient by itself without a yardstick with which to make compari- son. The original budget, or a later revised budget, is that yardstick.
Stage 5. Examining variances– differences between actual and budget items are called variances and significant ones need to be identified and their causes investigated. Significance here may be defined as an absolute sum of money or a specified percentage variation from budget.
Stage 6. Taking action if necessary– there is no point to the previous stages if this does not happen. Information may be gleaned that helps avoid future mishaps or repeats a benefit that can be transferred else- where. Every attempt should be made to get back on target if this is real- istically possible.
Stage 1. Setting new budget again– this starts the cycle off again but there is no point in setting a new budget after each monthly review as future comparisons may become meaningless. Some organizations keep the original budget fixed, get budget holders to forecast the outcome at the end of the budget year quarterly, and for the remainder of the year make comparisons against both original budget and latest forecast.
The budget is usually based on the accounting year of the organization and phased into shorter periods like monthly intervals. A typical example is shown in Figure 15.2.
July Aug Sept Oct Nov Dec Jan Feb Mar Apr May Jun Year SALES
Cost of sales GROSS PROFIT Salaries NICs Travelling exps Rent Business rates Light, heat Insurance Repairs & mtnce Stationery Telephone Postage General exps Audit fees Depreciation Bank charges Interest paid TOTAL O’HEADS NET PROFIT
Figure 15.2 Phased budget format for small enterprise
In medium-sized companies a more formal budgeting procedure will be required. Top management should specify broad objectives to a budget committee comprising representatives of both directors and functional managers. The committee then interprets these objectives into outline plans for each departmental head who in turn submit their detailed proposals. This process may continue a number of times to get the necessary integration and co-ordination of the individual budget proposals. Detailed instructions should be distributed to each budget holder including a timetable, budget formats and forecasts of price changes for the coming year.
Essentially, this is a bottom-up approach with managers retaining ownership of their budgets, as opposed to imposed or top-down budgets, where ownership and some motivation is lost. In practice, the iterative process usually adopted is a combination of top-down and bottom-up, with a few attempts made before a budget proposal is completed.
Budgetary control
When finally accepted by the budget committee, the functional budgets are aggregated into a master budget. This consists of:
ᔢ a budgeted profit and loss account for the year, phased into months;
ᔢ a projected balance sheet at the year end;
ᔢ a budgeted cash flow statement for the year.
If approved by the board, this becomes the policy to be pursued for the coming year. In many firms this procedure, outlined in Figure 15.3, is assisted by an accountant or budget officer, who supplies information and advice to all concerned.
Figure 15.3 Budget organization
Identification of key factor
The starting point with budgeting is to identify the key factor which limits the firm’s growth at this moment in time. In many firms this key factor will be sales volume but it could be a shortage of space, machinery, or materials. In many organizations, money itself will be the limiting factor, as is the case with local authorities and other grant-funded bodies.
1. Sales budget. Assuming sales is the key or limiting factor for a firm, this places the major responsibility for budgeting on the shoulders of the sales manager or director. The sales team will have to consider the present level of business, anticipate future trading conditions, obtain feedback from sales representatives and market research to come up with a sales budget. This budget is not just one total sales
figure for the coming year, but must be analysed by customers, by markets, by sales area and by months.
2. Production budget. After specifying sales, the production budget comes next. The level of production must equate with budgeted sales except when stock levels change. Where stocks are not required, or are kept at a constant level, production and sales volumes will be identical. Therefore the starting point for budgeting production is the sales budget after taking into account possible changes in stock levels or the use of subcontractors. Production levels must fall within existing capacity as otherwise production would have been identified as the key or limiting factor rather than sales. The production budget specifies the products to be made, when production is to take place, which departments are to be used and the cost of labour, materials and machine time.
3. Departmental overhead budgets.These are prepared based on the level of service needed to allow the sales and production functions to meet their budgets. The production department overheads will be geared to the production levels specified for those departments.
Similarly, the selling and distribution costs will be geared to the level of the sales budget while the various administrative departments’
budgets will be determined by the overall level of activity. Research and development also has a budget, but this is more a long-term investment of funds not closely related to short-term needs and is very similar to the capital budget mentioned later in Chapter 17.
In this way the various functional and departmental budgets are prepared which facilitate the composition of subordinate budgets for material purchases and manpower planning. The functional budgets form the basis for a master budget in the form of a budgeted profit and loss account and projected balance sheet. It is this master budget which goes to the board for approval and, if not satisfactory, the marketing/
production mix must be thought through again.
There is another budget which it is necessary for accountants to prepare using their professional skills and applying them to the vast store of financial information prepared in the budgeting process. The cash budgetis quite literally a monthly budget of cash inflows and outflows which are expected to arise from the plans expressed in the functional budgets. Details of its preparation and uses are contained in Chapter 18 on the control of working capital. A budgeted cash flow statementis also Budgetary control
prepared which is complementary to the cash budget in that it gives a summary of the reasons for all the cash inflows and outflows and any need for further financing in the budget period. This budgeted cash flow statement and the capital budgetdescribed in Chapter 17 are also part of the master budget going to the board for approval.
A schematic diagram of the budgeting process is shown in Figure 15.4.
Figure 15.4 The budgeting process
SALES BUDGET Analysed by products,
months, customers
PRODUCTION BUDGET Analysed by products, months, departments
Note For non-manufacturing organizations, this will
be replaced by an operations budget
MASTER BUDGETS Profit and loss account, balance sheet
Cash flow statement DEPARTMENTAL PRODUCTION/OPERATIONS
COST BUDGETS PURCHASE
AND MANPOWER
BUDGETS
DEPARTMENTAL ADMINISTRATION COST
BUDGETS
DEPARTMENTAL SELLING AND DISTRIBUTION
COST BUDGETS
Materials Labour Production Machinery Overheads
Budget periods
Budgets are concerned with the planned income and expenditure for the coming year. The accounting year is the natural choice for the budg- eting process, although it is broken down into months for regular comparison of actual with budgeted figures. These months may be of the calendar or lunar variety, or some other constant working period to avoid distorted comparisons due to the incidence of works and statu- tory holidays. Some firms work on a rolling year, adding a new month’s budget as each month passes. Other firms extend the budget horizon by asking for detailed forecasts of out-turn up to two years ahead, with looser forecasts for a further few years. In this way, top management start to build a picture of what the next five years’ results will look like and can adjust their strategic plans accordingly.
Budget reports
The comparison of actual results with budget takes place at two levels.
Each functional manager is fed information about the costs (and income) under his or her control, comparing actual costs against budget for the month under review and for the cumulative months of the accounting year so far expired. An example of this is given in Figure 15.5. Sometimes a distinction is made between controllable costs and costs reallocated to a department although not wholly within the manager’s control.
A line and subtotal may be drawn after controllable costs are listed.
This indicates to the manager concerned his/her achievement against budget for items he or she has both responsibility, and authority over. If other overheads are then listed over which the manager has responsibil- ity but no authority, care must be exercised in how this information is used to monitor that manager’s performance.
Figure 15.5 Monthly budget report
Budgetary control
At a higher level in the organization the actual profit achieved is compared with the budgeted profit and reasons for major differences reported to the board of directors. When a firm uses a standard costing system, the list of variances will link the budgeted profit with the actual profit achieved in the month. Where standard costing is inappropriate to the firm’s products, the monthly profit and loss account will compare budgeted costs and revenues with the actual costs and revenues respec- tively, to disclose the variances.
There is no point in drawing trivial variances to the attention of departmental managers or directors. Limits may be set as to what counts as a significant variance, being either a percentage of the budgeted figure and/or a certain sum of money. In this way time is not wasted on insignificant events and explanations are only required when a variance is deemed to be important.
Packages are available, or dedicated software can be written, to produce monthly budget reports for each department which integrate with the total financial results. Much budgeting work can now be performed on standard spreadsheets, such as Lotus 1–2–3 without having to go to additional expense. A particular advantage of using spreadsheets occurs at budget-setting time when what ifquestioning or financial modelling can produce budgeted financial statements under a number of different assumptions. These might relate to activity levels, selling prices, wage and other cost changes and changes in the economic environment, for example, exchange rates or interest rates.