Budgeting in different types of organization

In very large organizations, hundreds of managers may be involved in the budgeting process, and the complete budget will probably be a very thick document.


Budgeting when done well is time well spent

This involvement takes a lot of management time but, if the budgeting is done well, it is likely to be time well spent.

This is because the budget will probably be a realistic one, and because after approval the managers should feel committed to it.


Budget is approved - What happens next?

• When the budget has been approved, individual managers are responsible for their section of it.  the responsibility is like a pyramid.
• At the base of the pyramid are the most junior managers, supervising a comparatively small section, perhaps involving expenditure only.
• These junior managers should, however, have some knowledge of the overall budget and objectives.
• In the middle may be more senior managers and divisional directors, each with a wider area of responsibility for achieving the complete budget objectives.  If everyone else meets their targets they will have an easy job.

Budget must be relevant

Budgets should be designed to meet the needs of a particular organization and its managers.

For example, a large school could well have an expenditure budget of about $4 million.

• There will be little income and the budgeting emphasis will be on capital expenditure and revenue expenditure.  
• The main aims will be informed choice and value for money.

Main Principles of Budget for the Large and Small Companies

• The main principles devoted to the budget of a large company can also be used by a small organization.  
• There will be fewer managers involved, and less paper, but the same procedures should be followed.

After the budget has been approved ... what comes next?

After the budget has been approved, what comes next?  Quite possibly nothing at all.

This is a pity but it does not mean that the budgeting exercise has been a complete waste of time.

• The participants will have thought logically about the organization, its finances and its future.
• Some of the detail will remain in their minds and influence their future actions.
• Nevertheless, the budgets will be much more valuable if they are used in an active way.  

Regular performance reports should be issued by the accountants.

• These should be in the same format as the budgets.
• It should give comparable budget and actual figures.
• Variances should also be given.
• All levels of management should regularly review these figures and explain the variances.
• Significant variances will pose the question of whether corrective action needs to be taken.

Budgets do not necessarily have to be done just once a year.

They may be updated, reviewed or even scrapped and redone as circumstances dictate.

Cash Flow Forecast and the Balance Sheet Forecast

Cash-Flow Forecast

When the profit budgets are complete, it is important that a cash budget is prepared.

This is a Cash-Flow Forecast.  (click to understand this)

In practice, the profit budget and cash budget are linked.

• The profit budget cannot be completed until the interest figure is available.
• This in turn depends on the cash budget. 
• The cash budget depends partly on the profit budget.
• Dilemmas like this are quite common in budgeting.

It is usual to put in an estimated figure for interest and then adjust everything later if necessary.

This can be very time-consuming and budgeting is much simpler if it is computerized.

Several hours' work can be reduced to minutes and management is much freer to test budgets with useful "what if" questions.


Forecast Balance Sheet

Accounting rules stated that every debit has a credit.

It follows that every figure in the budgets has a forecast consequence in a future Balance Sheet.

It is normal to conclude the budgets by preparing a month-by-month forecast Balance Sheet and bankers are likely to ask for this.

It may be that some aspect of the Balance Sheet is unacceptable and a partial re-budget is necessary.

In practice, top management is likely to review and alter some aspects of the budgets several times.

The Capital Expenditure Budget

This is extremely significant in some companies, less so in others.

It will list all the planned capital expenditure showing the date when the expenditure will be made, and the date that the expenditure will be completed and the asset introduced to the business.

Major contracts may be payable in installments and the timing is important to the cash budget.

A sum for miscellaneous items is usually necessary.  For example, major projects might be listed separately and then $15,000 per month added for all projects individually less than $5,000.

Within the capital expenditure budget, timing is very important.

Expenditure affects cash and interest straight away.

Depreciation usually starts only on completion.

Revenue Expenditure Budgets

Revenue expenditure includes cost of sales (direct cost or variable cost) and overhead cost (indirect cost).

The cost of sales will consist of direct wages, items bought for resale, raw materials and others.

The Sales, Finance, and Administration Departments will make up the overhead budget.

In practice, this overhead budget is likely to be divided into three, with a different manager responsible for each section.

As with all the other budgets, each manager should submit a detailed budget for the section for which he or she is responsible.

As with the other budgets (e.g. sales budget), top management should give initial guidance on expected performance and policy assumptions.

For example, a manager might be told to assume a company-wide average pay rise of 5% on 1 January.

The Sales Budget

This should be in sufficient detail for management to know the sources of revenue.

The figures will be broken down into different products and different sales regions.

Each regional sales manager will have responsibility for a part of the sales budget.

Before the sales budget is done it would be normal for top management to issue budget assumptions concerning prices, competition, and other key matters.

The sales budget will be for orders taken.

There will usually be a timing difference before orders become invoiced sales.

The Profit Budget

There are usually several budgets and they all impact on each other.

The profit budget is arguably the most important.

There are two basic approaches to budgeting in a large organization, both having advantages and disadvantages..

1.   The "bottom up" method.  

• Proposals are taken from the lower management levels.  
• These are collated into an overall budget that may or may not be acceptable.  
• If it is not, then top management calls for revisions.

2.  The "top down" method.

• Top management issues budget targets.
• Lower levels of management must then submit proposals that achieve these targets.

In practice, there is often less difference between the two methods than might be supposed.

It is important that at some stage there is a full and frank exchange of views.

Everyone should be encouraged to put forward any constructive point of view, and everyone should commit themselves to listening with an open mind.

Top management will and should, have the final decisions.

It is a common mistake for managers to be too insular and to overlook what changes competitors are making.

All the budgets are important but in a commercial organization the overall profit budget is likely to be considered the most important.



Note the following points:

• Most budgets are for a year but this is not a requirement.  they can be for six months or for any other useful period.
• Most budget gives monthly figures, which is the most common division, but again this is not fixed.  the divisions can be weekly, quarterly or some other period.
• A summary budget is useful for a large organization.  The budgets leading up to these summarized figures will be more detailed.
• Various subsidiary budgets and calculations feed figures through to the summary budget.

Standard Costing

Standard costing involves the setting of targets, or standards, for the different factors affecting costs.

Variances from the standard are then studied in detail.


For example:

Standard timber usage per unit of production                       4.00 meters
Standard timber price                                                      $2.00 per meter
Actual production                                                                   3,500 posts
Actual timber usage                                                           14,140 meters
Actual cost of timber used                                                           $27,714


Material Price Variance is                                      $566 favourable (2%)
(14,140 x $2.00) - $27,714
= $28,280 - $27,714
= $566


Material Usage Variance is                                          $280 adverse (1%)
[(14,140 meters less 3,500 x 4.00 meters) x $2]
= [(14,140 meters less 14,000 meters) x $2]
= $280


The material price variance happens because the standard cost of the 14,140 meters used was $28,280 (at $2 per meter).  The actual cost was $27,714, a favourable variance of $566.

On the other hand, 140 meters of timber too much was used resulting in an adverse material usage variance.

Joel Greenblatt: Value Investing for Small Investors

Absorption Cost

Absorption cost takes account of all costs and allocates them to individual products or cost centers.


Direct or variable costs

Some costs relate directly to a product and this is quite straightforward in principle, although very detailed record-keeping may be necessary.

Among the costs that can be entirely allocated to individual products are

• direct wages and associated employment costs, 
• materials and bought-in components.

Indirect costs

Other costs do not relate to just one product and these must be allocated according to a fair formula.  

These indirect costs must be absorbed by each product.

There is not a single correct method of allocating overhead costs to individual products and it is sometimes right to allocate different costs in different ways.

The aim should be to achieve fairness in each individual case.  

Among the costs that cannot be entirely allocated to individual products are

• indirect wages (cleaners, maintenance staff, etc.), 
• wages of staff such as salesmen and accountants, and 
• general overheads such as rent and business rates.

Take care to allocate non-direct costs fairly

Great care must be taken in deciding the best way to allocate the non-direct costs.

There are many different ways.

The following two are common methods:

1. Production hours
2. Machine hours

Common Methods for allocating non-direct costs fairly

1.   Production hours

The overhead costs are apportioned according to the direct production hours charged to each product or cost center.

For example:

Consider a company with just two products.

Product A having 5,000 hours charged and Product B having 10,000 hours charged.  

If the overhead is $60,000.  Product A will absorb $20,000 and Product B will absorb $40,000.

2.  Machine hours

The principle is the same bt the overhead is allocated according to the number of hours that the machinery has been running.

For example:  

Consider a company that manufactures three types of jam.

Its overhead costs in January are $18,000 and it allocates them in the proportion of direct labour costs.

January Cost Statement

                                    

                                  Strawberry      Raspberry        Apricot         Total

Jars produced              26,000           60,000           87,000           173,000           

                                          $                    $                   $                      $

Costs                        

Direct labour                   2,000            4,000            6,000              12,000

Ingredients                      6,000           11,000          17,000              34,000

Other direct costs            2,000             3,000            6,000              11,000

Total Direct Costs         10,000           18,000         29,000              57,000

Overhead allocation         3,000             6,000           9,000              18,000

Total Cost                      13,000            24,000        38,000              75,000

Cost per jar                    50 sen            40 sen         43.7 sen           43.4 sen  

In the above, the direct labour is smaller than the overhead cost that is being allocated.

The trend in modern manufacturing is for direct costs and particularly direct labour costs, to reduce as a proportion of the total costs.  

If the overheads had been allocated in a different way, perhaps on floor area utilized, then the result would almost certainly not have been the same.

This increases the importance of choosing the fairest method of apportionment

Yield Curves and Breakeven Inflation

Real Yields = Nominal Yields - Breakeven Inflation

Break-even charts

In nearly all businesses, there is a close correlation between the level of turnover and the profit or loss.

The managers should know that if invoiced sales reach a certain figure the business will break even.

If invoiced sales are above that figure the business will be in profit.

The break-even point depends on the relationship between the fixed and the variable (or direct) costs.


Breakeven chart. 



The break-even point can be calculated by drawing a graph showing how fixed costs, variable costs, total costs and total revenue change with the level of output.


Fixed costs are shown as a flat line in the chart above..

The total costs are the result of adding the variable costs to the fixed costs.

The revenue is the result of sales.

The break-even point is when the total costs line crosses the revenue line.  It is at this point where these lines cross.

Profit and loss can also be read from the chart.

In practice, the relationships are rarely quite so straightforward, as some of the costs may be semi-variable.




More charts:

The uses of costing

It costs time and money to produce costing information and it is only worth doing if the information is put to good use.

The following are some of these uses.

1. To control costs
2. To promote responsibility
3. To aid business decisions
4. To aid decisions on pricing

1.  To control costs

Possession of detailed information about costs is of obvious value in the controlling of those costs.

2.  To promote responsibility

Management theorists agree that power and responsibility should go together, although often they do not do so

Timely and accurate costing information will help top management hold all levels of management responsible for the budgets that they control.

Care should be taken that managers are not held responsible for costs that are not within their control.  This does sometimes happen.

3.  To aid business decisions

Management must decide what to do about the unprofitable product.

4.  To aid decisions on pricing

We live in competitive times and the old 'cost plus' contracts are now virtually never encountered.

What the market will bear is usually the main factor in setting prices.

Nevertheless, detailed knowledge concerning costs is an important factor in determining prices.

Only in exceptional circumstances will managers agree to price goods at below cost.

They will seek to make an acceptable margin over cost.

Accurate costing is vital when tenders are submitted for major contracts and errors can have significant consequences.

Massive costing errors on the Millennium Dome at Greenwich were a spectacular example of what can go wrong.

Marginal Costing: Selling price > Variable or Direct cost ---> part of the Fixed cost is absorbed by the margin.

Marginal costing is a useful way of emphasizing the marginal costs of production and services.

This information is of great help in making pricing decisions.

If the selling price is less than the variable cost (direct cost),

• the loss will increase as more units are sold, and
• managers will only want to do this in very exceptional circumstances, such as a supermarket selling baked beans as a loss leader.

If the selling price is greater than the variable cost,

• then the margin will absorb part of the fixed cost, and,
• after a certain point profits will be made.

Why some goods are sold very cheaply at certain time?

Marginal costing explains why some goods and services are sold very cheaply.

It explains,f or example, why airline tickets are sometimes available at extremely low prices for last-minute purchasers.

• Once an airline is committed to making a flight, an extremely high part of the cost of that flight can properly be regarded as a fixed cost.  The pilot's salary will be the same whether the plane is empty or full.  
• The variable cost (direct cost) is only the complimentary meals and few other items.  
• It therefore makes sense to make last-minute sales of unsold seats at low prices.
• As long as the selling price is greater than the variable cost, a contribution is made (absorbing part of the fixed cost).

A basic understanding of the principles of costing is important in business management.

Most non-financial managers instinctively know that costing is important.

Unfortunately, it is probably also true that most non-financial managers do not know very much about it.

This is a pity because it affects so many business decisions.

For example, the fixed costs of running a cruise ship do not vary (or realistically only vary slightly) according to the number of passengers is the reason that large last-minute price reductions are often available. (Think of that when you book your holiday.)

A basic understanding of the principles of costing is important in business management.

The Working Capital Management: Success in managing debtors, stock and creditors affect cash.

The four largest elements affecting working capital are usually

• debtors, 
• stock, 
• creditors and 
• cash.

Success in managing the first three affect cash, which can be reinvested in the business or distributed.



Debtors

Many local businesses are plaqued by slow payment of invoices and it is a problem in many other countries too.

A statutory right to interest has been in place for a number of years but nothing seems to make much difference.

An improvement can significantly affect working capital.

It is a great problem for managers, who sometimes are frightened of upsetting customers and feel that there is little that they can do.

This is  completely the wrong attitude.

Customer relations must always be considered, but a great deal can be done.

Some practical steps for credit control are summarized below:

• Have the right attitude; ask early and ask often.
• Make sure that payment terms are agreed in advance.
• Do not underestimate the strength of your position.
• Give credit control realistic status and priority.
• Have well-thought out credit policies.
• Concentrate on the biggest and most worrying debts first.
• Be efficient; send out invoices and statements promptly.
• Deal with queries quickly and efficiently.
• Make full use of the telephone, your best aid.
• Use legal action if necessary.

This may sound obvious but it usually works.

Be efficient, ask and be tough if necessary.

Stock

The aim should be 

• to keep stock as low as is realistically feasible and 
• to achieve as high a rate of stock turnover as is realistically feasible.

In practice, it is usually necessary to compromise between 

• the wish to have stock as low as possible, and 
• the need to keep production and sales going with a reasonable margin of safety.

Exactly how the compromise is struck will vary from case to case.  

Purchasing and production control are highly skilled functions and great effort may be expended on getting it right.

"Just in time deliveries" is the technique of arranging deliveries of supplies frequently and in small quantities.  In fact, just in time to keep production going.

It is particularly successful in japan where, for example, car manufacturers keep some parts for production measured only in hours.

It is not easy to achieve and suppliers would probably like to make large deliveries at irregular intervals.  

It may pay to approach the problem with an attitude of partnership with key suppliers, and to reward them with fair prices and continuity of business.

Finished goods should be sold, delivered and invoiced as quickly as possible.

Creditors

It is not ethical advice, but there is an obvious advantage in paying suppliers slowly.

This is why slow payment is such a problem and, as has already been stated, the control of debtors is so important.

Slow payment is often imposed by large and strong companies on small and weak suppliers.

Slow payment does not affect the net balance of working capital,but it does mean that both cash and creditors are higher than would otherwise be the case.

Apart from moral considerations, there are some definite disadvantages in a policy of slow payment:

• Suppliers will try to compensate with higher prices or lower service.
• Best long-term results are often obtained by fostering mutual loyalty with key suppliers; it pays to consider their interests.
• If payments are already slow, there will be less scope for taking longer to pay in response to a crisis.

For these reasons it is probably not wise to adopt a consistent policy of slow payment, at least with important suppliers.

It is better to be hard but fair and to ensure that this fair play is rewarded with 

• keen prices, 
• good service and 
• perhaps prompt payment discounts.

There may be scope for timing deliveries to take advantage of payment terms.  

For example, if the terms are 'net monthly account', a 30 June delivery will be due for payment on 31 July.  At 1 July delivery will be due for payment on 31 August.

The Management of Working Capital. Is it important?

The effective management of working capital can be critical to the survival of the business and it is hard to think of anything more important then that.

Many businesses that fail are profitable at the time of their failure and failure often comes as a surprise to the managers.

The reason for the failure is a shortage of working capital.

Furthermore, effective management of working capital is likely to improve profitability significantly.

The percentage return on capital employed increases as capital employed is reduced.

Effective management of working capital can reduce the capital employed.

It increases profits as well as enabling mangers to sleep soundly without worries.

The four largest elements affecting working capital are usually

• debtors, 
• stock, 
• creditors and 
• cash.

Success in managing the first three affect cash, which can be reinvested in the business or distributed.

The Cash-Flow Forecast

It is extremely important that cash receipts and payments are effectively planned and anticipated.

This has not been done in nearly all businesses that fail.

A good manager will plan that sufficient resources are available but that not too many resources are tied up.

This can be done in isolation but it is better done as part of the overall budgeting process.



Cash-Flow Forecast will yield many benefits

The preparation of a detailed Cash-Flow Forecast will yield many benefits.

Calculating and writing down the figures may suggest ideas as to how they can be improved.

For example,

• the figures for cash payments from trade debtors will be based on the estimate of the average number of days' credit that will be taken.
• This will pose the question of whether or not payments can be sped up.

Are the Cash-Flow Forecast results acceptable?

When the Cash-Flow Forecast is finished it will be necessary to consider if the results are acceptable.

• Even if resources are available the results might not be satisfactory, and improvements will have to be worked out.
• If sufficient resources are not available, either changes must be made or extra resources arranged.  Perhaps, an additional bank overdraft can be negotiated.

Either way, a well-planned document will help managers to take action in good time.


Best illustrated in a table format

The principles of a Cash-Flow Forecast are best illustrated with an example in a table format.

Variations in the layout are possible but a constant feature should be the running cash or overdraft balance.

Do not overlook contingencies and do not overlook the possibility of a peak figure within a period.

What is cash?

Cash includes the notes and coins in the petty cash box.

It also includes money in the bank current accounts, and money in various short-term investment accounts that can be quickly be turned into available cash.

It is common for a Balance Sheet to show only a tiny amount for cash.  This is because the business has an overdraft and only such things as the petty cash are included.

Practical management usage of the term cash includes a negative figure for an overdraft.

A Cash-Flow Forecast can often result in a series of forecast overdrafts.

The distinction between Profit and Cash. A business can be profitable but short of cash.

Cash is completely different from profit, a fact that is not always properly appreciated.

It is possible, and indeed quite common, for a business to be profitable but short of cash.

Among the differences are the following:

1. Money may be collected from customers more slowly (or more quickly) than money is paid to suppliers.
2. Capital expenditure (unless financed by hire purchase or similar means) has an immediate impact on cash.  The effect on profit, by means of depreciation, is spread over a number of years.
3. Taxation, dividends and other payments to owners are an appropriation of profit.  Cash is taken out of the business which may be more or less than the profit.
4. An expanding business will have to spend money on materials, items for sale, wages, etc. before it completes the extra sales and gets paid.  Purchases and expenses come first.  Sales and profit come later.