Chapter 9 Budgetary Planning Preparation of the Master

Chapter 9 Budgetary Planning – Preparation of the Master Budget

Fixed budget ‘budget set prior to the control period and not subsequently changed in response to changes in activity, costs, or revenues. ’ Fixed Budget as defined by CIMA Official Terminology

The fixed/master budget The fixed or master budget sets out the plans for the business for the next accounting period based on various assumptions of sales and sales growth, inflation (in particular labour inflation), interest rates, taxation and capital expenditure. This master budget is known as the fixed budget as it is based on these fixed assumptions of trading performance and financial outlook. Its chief role is at the planning stage, in setting the overall direction or plan for the business

The master budget Operating Budgets Sales revenue Cost of sales Payroll and related expenses Other department expenses Fixed expenses Cash Flow Budget Capital Budgets Capital expenditure Stocks (related to purchases) Debtors (related to sales) Creditors (related to purchases) Master Budget q P&L account (Income statement) q Balance sheet q Cash flow

The master budget statements Profit and Loss Account A projected profit and loss account (income statement) includes all the revenues and expenses anticipated for the budget month under review. Balance Sheet Cash Budget A projected balance sheet is a statement of the expected position of an entity at the end of the budget month. It contains the expected monetary value of assets, liabilities and capital at the end of the budget month. Cash budgets are prepared in order to ensure that there will be sufficient cash in hand to cope adequately with budgeted activities. They must contain every type of cash inflow (money received) and every type of cash outflow (money paid).

Example 9. 1: The effect of sales in the master budget

Profit and loss extract (months 1 to 3) Sales revenue € 280, 000 € 80, 000 + € 100, 000 Cash Budget – Cash inflows Month 1 Month 2 Month 3 Cash sales (90%) € 72, 000 € 90, 000 Credit sales (10%) ______ € 8, 000 € 10, 000 Total sales receipts € 72, 000 € 98, 000 € 100, 000 Balance sheet extract as at end month 3 Current Assets 10% of € 80, 000 sold in month 1. Debtors € 10, 000 10% of € 100, 000 sold in month 3 not received. 10% of € 100, 000 sold in month 2.

Example 9. 2: The effect of purchases and stock in the master budget

Profit and loss extract for (months 1 to 3) € Opening stock 0 Purchases (€ 50, 000 x 3) 150, 000 Closing stock (20, 000) Cost of goods sold 130, 000 Cash Budget - cash outflows Month 1 Month 2 Month 3 Purchases 0 € 50, 000 Balance Sheet extract as at end month 3 Current assets € Stock Month 1 purchases are paid for in month 2. Month 2 purchases are paid for in month 3. 20, 000 Current liabilities Creditors 50, 000 Month 3 purchases are unpaid (due to be paid in month 4).

Other differences between P&L and cash budget The purchase cost or sales proceeds of fixed assets. Proceeds from the issue of shares Cash flows from the procurement or repayment of loans Depreciation of fixed assets

Forecasting ‘A prediction of future events and their quantification for planning purposes’ A forecast as defined by CIMA Official Terminology Three essential elements are required before one can begin to prepare projected financial statements. Forecast of sales. Forecast of costs / expenditure. Forecast of the required investment in net assets to achieve these sales.

Forecasting - factors influencing sales Past sales volume and mix Level of competition Quality of the product or service Consumer behaviour Strength of the brand name State of the economy Planned advertising expenditure Political and industrial outlook Pricing policy Local activities and events Capacity Seasonality Advance bookings Demand analysis

Forecasting - costs Fixed cost Variable cost Semi-variable cost

Forecasting – balance sheet items Debtors: Debtors tend to increase as sales increase. Stock levels: More stock is required to meet increased demand. Cash: More cash is required to meet increased costs associated with the increase in sales. Creditors: More credit is required from suppliers as purchases increase in line with sales. Accrued expenses: More accrued expenses occur as a result of increased overheads. Bank overdraft: A bank overdraft is frequently used to bridge any financing gaps caused by increases in activity. Fixed assets: As the business expands new fixed assets are required. (Note that fixed assets will not increase as sales increase, but only as the business reaches capacity and requires expansion). Hence there is a long-term relationship between sales and the fixed assets requirement. Long-term finance: As fixed assets expand, one will also expect longterm finance in the form of equity and more likely long-term debt to increase.

Other forecasting issues Taxation and rate of corporation tax. Variable interest rates on borrowings. The rate of inflation. The policies and commitments of the business. Capital expenditure Financing methods Dividend payouts

Example 9. 3: Projected financial statements

Projected financial statements and decision-making Is the projected profit satisfactory in relation to the risks involved and the required return on capital? If not, what can be done to improve this? Are sales and individual expense items at a satisfactory level? How adequate are the projected cash flows of the business and can they be improved? Should management consider additional financing? What type of financing is required, long, medium or short-term financing? What type of financial instruments are appropriate, debt or equity? Will there be surplus funds and if so, what plans have the company as regards investing these funds? Is the business overly financed through debt? How liquid is the business? Is the financial position at the end of the period acceptable?

Alternative approaches to budget preparation Incremental budgeting Zero-based budgeting Activity based budgeting Rolling budgets

Incremental budgeting ‘Method of budgeting based on the previous budget or on actual results, adjusting for known changes and inflation’ Incremental budgeting as defined by CIMA Official Terminology This is where the current budget and actual figures act as the starting point or base for the new budget. The major disadvantage of this is that the major part of the expense (the base) does not change and.

Zero-based Budgeting ‘Method of budgeting that requires all costs to be specifically justified by the benefits expected’ Advantages CIMA official terminology Fosters a questioning attitude to all revenues and costs. Focuses attention on value for money concept. Should minimise waste and result in more efficient allocation of resources. Disadvantages Costing and time consuming approch

Activity based budgeting ‘Method of budgeting based on an activity framework and utilising cost driver data in the budget setting and variance feedback processes’ Activity based budgeting as defined by CIMA Official Terminology ABB is an extension of the zero-based budgeting approach and goes into far greater detail in identifying value and non-value activities. It can be more effective than zero-based and incremental budgeting because: It avoids slack that is often included in the incremental approach. ABB focuses attention on each activity, highlighting those that do not add value.

Rolling budgets ‘Budget continuously updated by adding a further accounting period (month or quarter) when the earliest accounting period has expired’ Rolling budgets as defined by CIMA Official Terminology A rolling budget is a twelve month budget which is prepared several times each year (say once each quarter). The purpose of a rolling budget is to give management the chance to revise its plans, but more importantly, to make more accurate forecasts and plans for the next few months.

Rolling budgets Advantages Disadvantages Budgets are reassessed regularly and thus should be more realistic and accurate. Because rolling budgets are revised regularly, uncertainty is reduced. Planning and control is based on a recent updated plan. The budget is continuous and will always extend a number of months ahead. Rolling budgets are time consuming and expensive as a number of budgets must be produced during the year. The volume of work required with each reassessment of the budget can be off-putting for managers. Each revised budget may require revision of standards or stock valuations which is time consuming.