What’s it all about?
The techniques you will need to be able to plan the amount of sales you will make and how to make sure the stuff/service is available for you to sell.
The basic principles of budgeting.
The first thing we are going to ask ourselves, is why bother?
It’s a lot of work, whatever we come up with as a budget is going to prove to be wrong as there will be lots of changes (hence variance analysis) and our plans could change anyway.
Well the benefits of having a financial plan to go with your other plans are usually given as the six main functions of a budget. Not in any particular order.
1 Planning annual operations
Business will usually make long-term plans and long-term can mean over many years. After all, you can’t always switch businesses or enter new ones over night. It can be difficult to keep in mind the long-term plan when you have to deal with the day-to-day operations of your part of the business. Breaking your long-term plan down to practical chunks can keep you on track.
An annual budget should ensure that managers do plan for the future because it translates the long-term plan into manageable steps.
2 Co-ordinating the work of different parts of the business
Over a business there will most probably be several different departments. If left to their own devices, it might be difficult to ensure that they are run for the good of the company as a whole.
It might be that what you as the manager of the department would prefer to achieve in your department isn’t what is best for the business as a whole. The budget ensures that the work of every department is directed to what is best for the business.
It also should mean that Dept. A is making the stuff that Dept. B needs when they need it as the budget should tell Dept. A what to make when, keeping the business as a whole flowing smoothly.
3 Communicating the plans to all relevant managers
You plan each department’s work to achieve the company’s goals. The budget tells each department manager what they need to do and shows how it fits in with the work of other departments.
4 Motivating managers to achieve the organisations goals
A budget gives a planned outcome for the year. Depending on the department, it is probably broken down into outcomes for shorter periods – quarterly, monthly, weekly, daily etc. Each of these can be looked on as a target to be achieved and as such can be used to motivate managers and staff.
5 Controlling activities
If you know what you are supposed to be doing, you can make sure you continue to do what you need to. You can make sure that the right number of televisions are made, the right number of ironing boards are sold, the right number of raw materials are processed etc. If you are doing this, you can more effectively identify problems by looking for situations where you don’t actually achieve what you have budgeted.
Two examples of potential problems that can be avoided by having controlling budgets.
‘Type A’, saving the company money by buying in bulk. If every departmental manager bought everything they needed at the start of the year they would save money as they would get it cheaper. The company would probably go out of business by spending all its money at once though.
‘Type B’, saving the company money by doing the most efficient production. If your department makes televisions and ironing boards, you could save money by increasing efficiency by making all the televisions first, then all the ironing boards. You will save money, but the trouble is, your company won’t have any ironing boards to sell for the first half of the year!
Many businesses operate ‘management by exception’ – they use a reporting system that shows up where the budgeted activity is not achieved.
6 Evaluating the performance of managers
The manager knows what they have to do and you can measure whether they are doing it or not. This gives a good basis for determining how well a manager is doing their job. Relates closely to point 4, although of course you can monitor without actually having to reward managers.
Introduction to Budgeting
Discussion of the functions of budgeting in this analysis of an exam question.
What does a budget look like?
I strongly advocate taking this approach to layout:
Element Number of units of that element @ £cost per unit = £Total.
Illustrated with a making a table example:
Table tops. 1 @ £10 = £10
|Item||Number of units||£ per unit||Total cost|
How do you construct a budget? three simple (?) steps.
- Identify the limiting Factor
- Write the Sales Budget
- Write the Supporting Budgets
It’s what stops you from doing any more.
I am amused by demonstrating a management accounting principle with rabbits, but the ideas are the same.
The rabbit population grows (i.e we make more product) until a constraint (a limiting factor) stops the population growing any more (us making the product).
If we can overcome the limiting factor e.g. by providing more habitat, or protecting from hunting, then the rabbit population will grow until a new limiting factor comes in to play. In business, if we can overcome the limiting factor we will make more product until a new limiting factor stops further production.
In a business situation we might have a demand of 100, enough material to make 120, enough machine hours to make 90 and enough labour to make 80.
Labour would be the limiting factor. If we had enough money and spare labour existed we could overcome the limiting factor of labour and then make 90. At this point the next limiting factor (capacity on the machine) has kicked in. If additional machines exist for hire/purchase and we have the money, we could overcome this too. If we haven’t, then we will be stuck at making 90.
Note, that even if we had the machine hours and labour hours to support it we would not make the 120 units that the material we have would allow. There wouldn’t normally be any point in making more than demand (what we can sell). That’s where we differ from the rabbits.
(We also talk about ‘contribution per unit of limiting factor’, but that’s a different thing dealt with elsewhere – it’s not about setting a budget, it’s about making sure you do the most profitable thing when you are going to not have enough stuff).
2. Once we know the most we can make, that will be the number that goes into our Sales Budget. It is simply the units we are going to sell x the £price per unit to give us a our £total income.
3. Then we can write the Supporting Budgets.
These are all the things we need to spend money on to be able to sell the number of units we said we were going to sell (in the Sales Budget).
So, if we said we were going to sell 100 tables, the supporting budgets would include a budget for purchasing 100 table tops, another for purchasing 400 table legs and so on for all the variable costs.
There would also be budgets for overheads (fixed costs) associated with manufacturing (Factory overhead) and Sales & Distribution Overhead and Administration Overhead. you will remember that these are largely Fixed Costs (but not always).
Breaking the budget down.
Having just one number for an item in a budget isn’t terribly helpful. Knowing you are going to plan to sell 48,000 units in a year isn’t really enough information. You really want to know that you are going to sell 4,000 units a month. (We look elsewhere at how you calculate sales per month when you don’t sell exactly the same amount every day).
So it is normal to show your budget as monthly ‘instalments’.
J F M A M J J A S O N D
What is you are not certain what is going to happen later in the year though?
Why not show detail where you can and lump other months together until you are more confident of your predictions. Show Quarter 4 instead of October, November, December perhaps.
J F M A M J J A S Q4
You can then add the detail later when you get closer to those months.
It’s not compulsory to have a 12 month (annual) budget, it can be as long or short as you wish. The further away though, the less detailed you can probably be.
I worked for a company once that wrote its budget for the year once the year had started, effectively it was march before we knew what the plan was for the year. It was dreadful.
You can overcome this by having a rolling budget. You work twelve months ahead, but as a month is passed through, you add another one on at the end.
J F M A M J J A S O N D
J F M A M J J A S O N D J
Or you could do it a the end of a quarter.
J F M A M J J A S O N D J F M
If you are not confident of the detail, you could add just a summary quarterly figure.
J F M A M J J A S Q4
Note how as we get closer to Quarter 4 we are able to add detail for the months in that quarter.
J F M A M J J A S O N D Q1
It really is up to you how you do it. I worked with a charity that got funding every three years. We wrote a three year budget. Detailed for year one, less detail (quarterly for year two) and a summary for year three. As we worked through the three years, we added detail to the later months and quarters.
Is there a difference really? The writer below thinks so, but I tend to think it is splitting hairs. (I was tempted to say hares as we had rabbits above, but who wants bad puns in their accounting materials?) Unless you know with absolute certainty what your costs are going to be (and who does?) all budgets are also forecasts in my view.
Others might think differently.
“As a CFO, I am frequently asked what the differences are between a forecast and a budget. Think of a forecast as what you want to happen in the future, while a budget helps you manage what will happen now. These are two financial planning tools business personnel may use in the decision-making process.”
Seasonality and Budgeting.
We look at this in much more detail under Time Series Analysis, but we can also consider how known seasonal changes in sales etc. affects budgeting. It can also affect your budgeting for services.
One in six drink related incidents on railways happens in just 40 days (just over a tenth of the year). Could do Pareto Analysis here too!
The weaknesses of budgeting. several issues covered in this article.
How you can use a Flexible Budget for different levels of activity.
A useful video overview of budgeting (about an hour long). There’s a good mnemonic for remembering the importance of budgeting. Also interesting discussion of the budgeting process in an organisation. this would be useful to view if you are likely to be asked about the ‘psychology’ of budgeting – negotiation/over and understating budgets/ conflicts etc – sometimes called ‘behavioural aspects of budgeting‘. I tend to focus in teaching on the maths and formats, so this view on the use in industry will be useful for you.
This video is about budgeting in a care home in the USA.
Some good introductory material about why we budget and some good practical advice on budgeting. The latter won’t be of use to you in an exam question, but you should find interesting to see how we transalte theory into practice. Certainly give it a view if you are planning a real budget.
How and why… a short webinar.
Plenty on practicalities in software.
The Planning Fallacy … we continually underestimate time, resources costs in planning.
See the mimi course at:
I keep additional materials worth reading at this location:
Good introduction to budgeting for new small businesses including a customisable template: http://quickbooks.intuit.com/r/budgeting/budget-planning-what-to-know-before-you-launch
When we calculate the number of employees we need to do the number of hours of work we need to pay for to get a job done, we always take into account annual leave! Not so Ryanair who appear to have completely forgot to budget for when their pilots will need to take their contractual leave.
Budgeting in practice.
An example from the dairy industry. Always interesting to see how things are done in practice. do you agree with the calculations?
Is budgeting still relevant?
Article from this site: http://bbrt.org/is-the-budgeting-process-still-fit-for-purpose/
Other approaches to budgeting – Participatory Budgeting.
Being a little cynical (and a politician previously myself) I am not sure if this is really taken seriously by politicians or is just a sop to the voters. is it something that businesses could adopt, allowing the staff to have more involvement in decision making?
Possible Written Questions.
(No indication of marks – the more marks a question gets, the more you are expected to write – detail that is, not just words!) If you can’t answer these, you need to do some more reading. I do ‘find’ questions elsewhere, so these aren’t all questions I have used myself.
Outline the steps in the production of a Master Budget.
Outline the problems associated with budgeting.
What are the advantages of preparing a Budget?
With reference to behavioural theorists, critically discuss how Management Accountants can overcome issues related to motivation in the Budget Setting process.
Discuss how theorists have shed insight into the behavioural aspects of budgeting and how management can overcome any negative motivational factors.
What are the three steps in constructing a budget?
What are the six functions of a budget?
Explain how budgeting fits into the overall planning and control framework of a business.
Identify and describe the six different purposes of budgeting.
Identify and describe the various stages of the budget process.
Explain what is meant by the term ‘Limiting Factor’.