Basics of Budgeting BUDGETING Definition A budget is
Basics of Budgeting
BUDGETING Definition : A budget is a quantified expression of the intentions of the management and operates in a fashion that enables attainment of orgainsational goals. Elements of a Budget 1. It is a comprehensive and co-ordinated plan. 2. It is expressed in financial and physical terms. 3. It is a plan for the company’s operations and resources. 4. It is a future plan for a specified period.
MAJOR OBJECTIVES OF BUDGETING 1. To state the company’s goals. 2. To communicate expectations to all concerned. 3. To provide detailed plan of action for reducing uncertainty. 4. To co-ordinate activities and efforts in such a way so as to maximise resources. 5. Measure for controlling performance.
TYPES OF BUDGETS Comprehensive Budgeting involves the preparation of a Master Budget. The three important components of Master Budget are: i) Operational / Functional Budgets ii) Financial Budgets iii) Capital Budgets
ESSENTIALS OF BUDGETING 1. Senior management support 2. Clear and realistic goals 3. Assignment of authority and responsibility 4. Creation of responsibility centres 5. Adaptation of accounting system 6. Full participation 7. Effective communication 8. Budget education 9. Flexibility
Budgeting As a Tool of Management Planning and Control • • Communication Coordination Performance Evaluation Motivation Fundamental Concepts & Techniques Used for Budgetary Control • Cost benefit analysis including the social cost benefit analysis. • Contingency approach • Responsibility accounting based on the technique of variance analysis • Value analysis for services, systems, cost incurrence etc. • Application of mathematical models such as PERT, CPM, Transportation & Assignment models, L. P. & Simplex Models, Scrutiny Analysis etc.
b – A Structured Approach Budgeting Process § Formation of Multipurpose Budget Team § Definition of Vision/Mission/Objectives § Exhaustive analysis of : - Competitive Environment - Economic Environment - Political Environment - Business SWOT - New Product Strategies - Corporate Strategic Initiatives e. g. . , New/ Restructured Alliances at Industry and Company level Continued …
Continued … • Agree on Volumes and Price Realisations • Work on related linkages (at various companies, various business etc. viz. , Manufacturing, Logistics, etc. ) • First pass preparation of Income/Capital Employed Statements • Budget Package Finalisation Continued …
Continued … Volumes and Price Realisation determination • Territywise/Productwise Volume and NRV determination (Net Realisable Value). • Inputs on Brand Pricing, Product Positioning , Past Product Performance Analysis, Proposed Product Lines from Marketing and Technology Teams. • Deliberations on the above done by the Budget Team to determine Volumes and Prices Regionwise Continued …
Continued … • Zero base build up, other than Fixed Commitments • Projected Business Growth • Determination of Sales Regions/ Territories • Manpower Requirement • New Product Launches • Proposed Brand Plans
Continued … Manufacturing Budget Preparation Capacity Fixation of RM/PM Costs Volumes Inventory Import Plan Production Plan Labour Variable Utilities Operations Cost Fixed Standard Cost of Goods Sold
Continued … Logistics Cost Plan Determined by the Production Plan, Import Plan and Despatch Plan
FUNCTIONAL / OPERATIONAL BUDGETS 1. Sales budget 2. Production / Operations 3. Material Consumption 4. Purchase 5. Labour 6. Overheads 7. Marketing and Selling 8. Administration and Finance
AN OVERVIEW OF BUDGETING PROCESS A PLAN OF OPERATIONS Management’s Goals and Objectives for the year Formalised in THE ANNUAL PROFIT PLAN SUPPORTING SUBBUDGETS, CASH BUDGET, INVENTORY BUDGET, CAPITAL EXP. BUDGET, OTHERS THE BUDGETED B/S ASSETS/ LIABILITIES OWNER’S EQUITY THE FINANCIAL BUDGET Composed of Wherein Mgmt. Specifies The Entire PLAN OF OPERTIONS is finally reflected in THE OVERALL INCOME OBJECTIVE Detailed in SALES BUDGET in Qty/Territory/ Product and Time Period OTHER INCOME BUDGET Interest Income / Royalty etc. [PURCHASE BUDGET] [DIRECT LABOUR BUDGET] [FACTORY O/H BUDGET] All the below are prepared for pre decided time period involved Less THE OVERALL COST & EXPENSE OBJECTIVE detailed in DISTRIBUTION EXP. BUDGET By Territory ADMIN. EXP. BUDGET By Department OTHER EXP. BUDGET Interest Exp. Etc. PRODUCTION BUDGET Unites to be produced
TABLE SHOWING VAROUS FACETS OF A BUDGET PROGRAM Name of Budget What it shows Prepared by Classification by Historical Analysis Business Conditions Salesman's Report Market Analysis, Special Conditions Sales Budget, Production Capacity, Stock Requirements Product Territory Customers, Salesmen, Period Production Manager Production Budget Product /Department, Period & Elements of Costs Production Manager & Costing Department Production Budget and Stocks on hand Item wise (Major) Production Labour Hours and Cost needed Manager & Costing for (2) Department Estimated Over Production Heads expenses Manager & Costing for (2) Department Production Budget Category/Skill wise Production Budget and fixed expenses Expense Wise Department Wise 1) Sales Budget Estimated sales of products Sales Manager 2) Production Budget Estimated Quantity of Production Manager 3) Production Cost Budget Cost of Production 4) Materials & Stores Quantity & Value of Materials needed for (2) 5) Labour Budget 6) Production Over Heads Based upon Product, Department, Period
FLOW CHART OF BUDGETARY CONTROL Specification of organisational objectives and identification of key factors Sales Budget Operations Budget for Prime Cost & Overhead Budget for Sell. & Dist. Cost Cap. Expend. Budget Cash Budget Administrative Cash Budget Master Budget Acc. & Resp. , Var. analysis Managerial Action
Summary of Steps in Budgetary Control 1) 2) 3) 4) 5) 6) 7) 8) 9) 10) SWOT analysis for deciding objectives Preparing a budget statement Recording the actual performance Periodic comparisons between the budgeted and actual performance, & finding out the favourable and unfavourable variances Finding out the causes grouping these variances Basis the cause grouping these variances as “controllable” and “uncontrollable” Deciding the quantum of reward or penalty for the individual or the teams for the variances Revising the standards to suit the cyclic – environmental and uncontrollable changes in conditions. Go through the steps 2 to 7 again Thus the process of budgetary control has to be continuous, flexible and unbiased
ADVANTAGES OF BUDGETING 1. Forced planning. 2. Co-ordinated operations. 3. Performance evaluation & control. 4. Effective communication. 5. Optimum resource utilisation. 6. Productivity improvement. 7. Profit mindedness. 8. Efficiency. 9. Cost control.
LIMITATION IN USING THE BUDGETING SYSTEM 1. Management judgement. 2. Continuous adaptation. 3. Implementation. 4. Management complacency. 5. Unnecessary detailing. 6. Goal conflict. 7. Evaluation system. 8. Unrealistic targets.
VARIOUS STYLES OF BUDGETING 1. Flexible Budgeting 2. Zero Base Budgeting 3. Activity Based Costing 4. Balanced Score Card
PROFIT PLANNING AND CONTROL Consider the following data: EXHIBIT I Sales Rs. Sales Variables Cost Contribution Margin Fixed Cost Operating Profit Financing Costs (@10%) NPBT I. T. @ 50% NPAT Owners Funds Borrowed funds Capital Employed 10, 000 6, 000 4, 000 1, 000 3, 000 50, 000 2, 50, 000 1, 25, 000 5, 00, 000 10, 000
EXHIBIT II [A] OPERATING MANAGEMENT PERFORMANCE: (A) =(a) x (b) x(c) = 75% x 40% x 100% = 30% (a) P/V Ratio = Contribution Margin Sales (b) Margin of Safety Ratio = = 40% Operating Profit = 75% Contribution Margin Sales (c) Turnover Ratio = = 100% Capital Employed
B] FINANCIAL MANAGEMENT PERFORMANCE: (B) = (d) x (e) = 41% x 200% = 82% (d) NPAT. = 41% OPERATING PROFIT (e) Capital Employed Owner’s Funds = 200%
[C] OVERALL MANAGEMENT PERFORMANCE: (A) =(B) = 30% x 82% = Approx 25% EXHIBIT III BREAK EVEN ANALYSIS A 75% Margin of safety indicates if sales fell by 75%, losses will start (as shown hereunder) Sales (reduced by 75%) 2, 50, 000 Variable Costs @60% 1, 50, 000 Contribution Margin 1, 000 Fixed Costs 1, 000 PROFIT ZERO. Thus the sales level of Rs. 2, 50, 000 is the “NO PROFIT – NO LOSS” point or the BEP which is also defined as:
BEP = Fixed Costs x Sales – Variable Costs BEP = = 1, 000 X 10, 000 4, 000 Fixed Cost P V Ratio = 2, 50, 000 It is defined in units as under: BEP = Fixed Costs x Sales Unit Contribution Margin
EXHIBIT IV SENSITIVITY ANALYSIS OF OPERATING MANAGEMENT PERFORMANCE BASIS BEP In the existing situation OMP is planed @30% on capital employed. With the help of BEP Analysis we can now check its sensitivity to various factors as under:
1. What should be the sales level to increase the OMP to 40% level? BEP = Fixed Costs + Desired Profit PV Ratio = 1, 000 + 4, 000 40% Computation of operating profit at new sales level: Sales 12, 50, 000 Variable Costs (60% of Sales) 7, 50, 000 Contribution Margin (40% of Sales) 5, 000 Fixed Costs 1, 000 Operating Profit 4, 000 = 12, 50, 000
2. What should be the variable costs level to increase the OMP to 40% level? Fixed Costs + Desired Profit BEP = PV Ratio = 10, 000 = 1, 000 + 4, 000 PV Ratio = 5, 000 10, 000 = 50% = Contribution Margin Sales
Computation of Operating Profit at new variable costs level: Sales 10, 000 Variable Costs 5, 000 Contribution Margin@ 50% 5, 000 Fixed Costs 1, 000 Operating Profit 4, 000
3. What should be the fixed costs level to increase the OMP to 40% level? BEP = Fixed Costs + Desired Profit PV Ratio = 10, 000 = Fixed Cost + 4, 000 40% 4, 000 = Fixed Costs + 4, 000 Fixed Costs = Zero
Computation of Operating Profit at New Fixed Costs Level: Sales 10, 000 Variable Costs 6, 000 Contribution Margin 4, 000 Fixed Costs Operating Profit Zero. 4, 000
VARIOUS STYLES OF BUDGETING 1. Flexible Budgeting 2. Zero Base Budgeting 3. Activity Based Costing 4. Balanced Score Card
Balance Score Card
Origin • Developed by Robert Kaplan and David Norton • Communicate Companies’ Objectives, link them to strategy • Translates mission and strategy into four perspectives
The Balance Scorecard Perspectives • Financial • Customer • Internal business processes • Learning and growth
Building a Balanced Score Card More than a mixture of 15 to 25 financial and non financial measures to reflect the business unit’s strategy by linking outcome and performance measures together. Core Financial Measures • ROI/Economic value added • Profitability • Revenue growth/mix • Cost reduction productivity
Financial Perspectives • Is strategy implementation improving the bottom line? • Shareholder value addition Steps: - improve ROI - reduce cost - increase revenue - manage risks etc.
Building a Balanced Score Card …… Core Customer Measure • Market share • Customer acquisition • Customer retention • Customer profitability • Customer satisfaction
Building a Balanced Score Card …… Core Learning and Growth Measures • Employee satisfaction • Employee retention • Employee productivity
Learning & Growth Perspectives • Identify infrastructure to create long-term growth and improvement • 3 principle sources of learning - people - systems - organizational procedures • Measurement of employee satisfaction, retention, training & skills • Aligning incentives with overall organizational success factors
Internal Business Process Perspectives • Identify critical internal processes • Help to deliver value propositions to attract and retain customers • Satisfy shareholder expectations of excellent financial returns - innovation - operations - post sales service
Limitations • Are 4 perspectives sufficient? • No incorporation of other stakeholders’ interest like suppliers and the community
Conclusions • The Balance Score Card is basic tool • Can be modified & customized according to an Organization's needs • An important weapon in every manager’s arsenal
Flexible Budgeting It is a budget which by recognizing the difference between fixed, semi fixed and variable costs, is designed to change in relation to the level of activity attained. It is a budget prepared for a range and is also known as variable budget or a sliding scale budget. Steps in flexible budgeting: 1. Deciding the range of activity 2. Determine cost behaviour patterns 3. Selecting the activity levels to prepare budgets at those levels 4. Prepare budget at each activity level
Zero Base Budgeting ZBB is a method of budgeting whereby all activities are revalued each time a budget is formulated and every item of expenditure in the budget is fully justified. That is, ZBB involves starting from scratch or zero.
Implementation of ZBB involves the following : 1. Each activity of the organisation is identified and called a decision package 2. Each decision package must be justified 3. If justified the minimum cost to sustain each decision package is determined 4. Alternatives for decision packages are evaluated 5. Managers rank their decision package in order of priority for resource allocation 6. Resources are allocated to the package
ADVANTAGES OF ZBB 1. Allocation of resources by need and benefit. 2. Identifies and eliminates wastage's and obsolete operations. 3. Best possible methods of performing jobs is ensured. 4. Increased staff involvement which may lead to improved motivation and greater interest in job. 5. It increases communication and co-ordination within the organisation. 6. Managers become more aware of cost inputs which help in identifying priorities.
DISADVANTAGES OF ZBB 1. Substantial Cost & time involved in preparing a large number of decision packages. 2. Managers could develop fear and feel threatened by ZBB. 3. Ranking of packages could result in departmental conflict.
Learning Curves and Non Linear Costs The learning curve phenomena is based on the concept that costs tend to be non linear. It is found that the cost of doing most tasks of a repetitive nature decrease as experience at doing these tasks accumulate. Most experience curves, estimated on actual process, indicate that costs decline 20 to 30 percent each time accumulated experience doubles.
Factors that lead to this long-run decline in costs include: 1. Labour efficiency. 2. New process and improved methods. 3. Product stadardisation. 4. Scale effect.
Activity Based Costing In Activity based costing (ABC) costs are first traced to activities and then to products. It is a system which focuses on activities performed to produce products. Activities become the focal point of cost accumulation. ABC involves two primary stages - Tracing costs to activities - Tracing activities to products
COST DRIVERS IN ABC 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. Number of receiving orders. Number of purchase orders. Number of dispatch orders. Number of units. Amount of labour cost involved. Number of material handling man hours. Number of direct labour hours. Number of vendors/ suppliers. Number of set up hours. Number of employees. Number of labour transactions.
TRADITIONAL COSTING Overhead Cost P 1 Process / Job 1 P 2 Process / Job 2 P 3 Process / Job 3 Stage 1 : Overheads assigned to cost centres/ pools. P R O D U C T Stage 2 : Overheads assigned to products using cost driver rate.
ACTIVITY BASED COSTING P 1 Overhead Cost Activity 1 P 2 Activity 2 P 3 Activity 3 P 4 Activity 4 P 5 Activity 5 Stage 1 : Overheads assigned to cost centres / pools. P R O D U C T Stage 2 : Overheads assigned to products using cost driver rate.
REVENUE MANAGEMENT - TOPLINE Rule I Price then costs Intuition In high demand times, increase productive capacity. In periods of low demand, reduce capacity and lower headcount. Entropic Event: Demand fluctuations growing in frequency and intensity R. M. P. I Address short term fluctuations with price, then capacity planning in long run.
Rule II Value management and marketing value based pricing dominates cost based pricing. When customers dominate – value dominates and they do not care about your costs; you care if cost based price exceeds customer’s value. Find market acceptable price point. Move from cost-based pricing to price-based costing. Intuition Set prices to cover costs and provide an acceptable margin (Cost Based Price: CBP) Entropic Event: Non-conformist customers determine the price: Marketing provides the choices. R. M. P. II Move from CBP to PBC Monitor market for both Revenue Management (RM)& Cost Management (CM) for Profit Management (PM)
Rule III Sell to segmented micro-markets and not mass markets Seek and seize revenue advantage rather than worry about cost disadvantage. Faster-Better-Cheaper mantra What is this customer willing to pay for this product at this point in time. There is no average consumer, thus there can not be an average price. Intuition Price is set to sell the greatest number of units at the highest possible price in the mass markets. Entropic Event: Consumer individualism and amoeba market shatters the myth of mass market. R. M. P. III Different segments demand different prices. To maximise revenue with competition, prices must vary to meet the price sensitivity of each market segment
Rule IV Save your product for your most valuable customers “First Come, First Served” do not ensure RM or PM Makes relevance only when there is shortage Customers who are paying less are those who come First Favor the most valuable customers Intuition Sell products and services on a “First Come, First Served” basis Entropic Event: Traditional business practices do not satisfy investor demand for revenue growth. R. M. P. IV Forecast and understand demand at micro-market levels and save products for the most valuable customers through prioritization.
Rule V Decisions should be based on knowledge and not supposition Data Information Knowledge Profit Adopt a RM program of appropriate size and scope Understand window of opportunity and volatility Understand intentional/unintentional biases and availability of information bias while forecasting Intuition Assumptions are and can be made about future consumer behaviour based on intuition and personal observation Entropic Event: Non-conformist consumers are continuously fragmenting the market and changing buying behaviour R. M. P. V Forecast demand at the micro-market level, gain knowledge of subtle changes in consumer behaviour patterns and then optimize on Product/Consumer/Supply or Demand.
Rule VI Exploit and leverage each product’s value cycle. Maximise value of product in micro-markets over time Adopt a RM program of appropriate size and scope Get as much money as possible as soon as possible Entertainment – Movie business example Intuition Decisions on product availability and pricing are made based on experience, gut feel, tradition or rule of thumb. Entropic Event: Rapidly changing market conditions defy conventional approaches R. M. P. VI Maximise revenue by understanding the value cycle and optimally timing the availability and price of the product to each micro-market segment. The sales force in the trench should be armed with decision support tools built upon appropriate databases so they can make dynamic decisions at the micro-market level.
THE CRUX OF BUDGETING Facts Data Knowledge Information Wisdom Analysis Profit Optimization Forecasts Turn Facts into Profit!
- Slides: 61