Introduction to Management
Accounting (IMAC01-5)
Topic Five
INTRODUCTION
This topic relates to the following module outcome:
• Contribute to the composition and interpretation of different types of budgets as tools of financial
planning and control.
• This topic introduces the fundamentals of the budgeting process. A corporate budget is a very
important financial tool in any business.
• A budget holds management accountable by helping them to plan properly and allocate resources
so that the company can run smoothly and efficiently.
• A comprehensive corporate budget should include sales, production, operations, purchasing,
overheads and capital.
• The capital budget serves as a planning tool to assist the company with its acquisition of required
assets to stay on track with its financial objectives.
• The essence of budgeting is to determine what sources of revenue are available, as well
as the expenses to be incurred in running the business.
• The various types of budgets will be covered and how they are prepared.
• The budgeting process benefits management in planning ahead to anticipate changes in
the market and to plan for such changes in this very volatile business environment.
In this topic, you will gain knowledge in the following areas:
1. Types of budgets
2. Alternative budgeting techniques
3. Benefits and limitations of budgeting.
PURPOSES OF BUDGETING
• A budget is a plan of action for a defined period expressed in a quantitative form. This
may include costs and expenses, resource quantities, planned sales volumes and
revenues, assets, liabilities and cash flows. The budget committee must also take into
consideration the external environmental conditions, the state of the economy, and the
trends of the industry the company is involved in.
• A budget compels managers to look forward or plan for the future and reflect on the
needs of the business. These could vary, ranging from rental space, to staff needs, to
stock-holding requirements.
• Budgets are very important tools in ensuring that management have control of income
and expenditure.
• A budget is a plan to:
• control the finances, provide reasons for deviations from the budget and allow for
investigations into controllable or uncontrollable items.
• ensure management can continue to fund the current commitments by planning ways in
advance before event come to pass.
• enable management to make confident financial decisions and meet the objectives. It
motivates employees and management to achieve targets.
• ensure that management have enough money for future projects.
• Budgeting facilitates communication in the business when senior managers make
junior managers aware of their plans. The communication process is a two-way
stream, sharing information and giving instructions to subordinates.
Characteristics of a good budget
A budget should be characterised by the following:
• Good co-operation must be established between all the key stakeholders in the business
responsible for certain sections of the budget.
• The budget must provide a holistic overview of the entire company and all its different
sections.
• It must follow the standard outline and procedures drafted by the business.
• It must be flexible and make provision for unplanned and changing circumstances.
• It should have an established feedback process to monitor performance and provide
timeous feedback to all relevant stakeholders.
The scope of a budget
A master budget is a budget that includes all the functional budgets namely:
• Projected cash-flow – the cash budget projects the future cash position on a month-by-
month basis.
• Budgeting in this way is vital for small businesses as it can pinpoint any difficulties the
business is experiencing. It should be reviewed at least every month.
• Costs – the budget makes provision for three kinds of costs:
• Fixed costs – items such as rent, salaries and financing costs.
• Variable costs – including raw materials and overtime.
Revenue – revenue streams are also determined.
• Sales or revenue forecasts are typically based on a combination of the sales history
and how effective the financial manager or owner expects the future efforts to be.
During budget preparation the following question will arise:
• What are the projected sales for the budget year?
• What are the direct costs of sales – i.e. costs of materials, components or
subcontractors to make the product or supply a service?
• What are the fixed costs or overheads?
Management should break down the costs into variable, fixed and overheads, for
example:
• Cost of premises, including rent, municipal taxes and service charges
• Staff costs – such as wages and benefits
• Water and electricity
• Printing, postage and stationery
• Vehicle expenses
• Equipment costs
• Advertising and promotion
• Travel expenses
• Legal and professional costs, including insurance.
Key performance indicators
To boost the performance of a business, management need to understand and
monitor the key drivers of the business. A driver is something that has a major
impact on the business. There are many factors affecting the performance of
every business, so it is vital to focus on a handful of these and monitor them
carefully.
The three key drivers for most businesses are:
1. sales
2. costs
3. working capital.
Advantages of corporate budgeting
• Cost control - An area where a corporate budget might serve a company most is cost
control.
• Budgets enable their users to remember that resources are limited.
• Employee motivation
Budget preparation process
• Budgeting is a two-step process – planning the budget and executing it.
• Review expenses: Start the budgeting process by reviewing all expenses over a certain
period, for example, six months.
• Identify fixed and variable expenses:
• Prioritise expenses:
• Identify when expenses must be paid:
• Balance income and expenses
• Review expenses regularly:
• Create an emergency fund to cover unexpected expenses.
• Reduce debt.
A FRAMEWORK FOR BUDGETING
The budget committee
• The budget committee will include the chief executive officer, the chief financial officer and
functional heads of the various divisions in the business. The budget committee will comprise
representatives from all departments including the sales, product, market and other
departments.
• Functions of the budget committee include the following:
• Drafting the rules and procedures
• Empowering and assisting line managers
• Reviewing and correcting individual departments’ budget proposals
A FRAMEWORK FOR BUDGETING
The budget committee
• Providing feedback on proposed budgets
• Approving various budgets
• Assessing the implementation process
• Providing suggestions on how to improve the budgeting process .
A budget manual may contain the following:
• The company’s policy and procedures for drafting a budget
• The responsible people (stakeholders) in the process
• The documentation that goes along with the budget process
• A list of the company’s account codes to be used for the various items in the budget
• The method of preparation for departmental budgets and master budgets
• The time frames for key deliverables
• The process from inception to completion and the various checkpoints to take note of
• Approval system and feedback.
Stages in the budget process
The following steps need to be followed:
• Align your company goals and objectives with your budgetary requirements..
• Assess the financial position of the company,
• Do a comprehensive analysis of sources of revenue and how revenue can be increased.
• Track expenses
• Categorise all expenses.
• Design appropriate spreadsheets to simplify the budget process.
• Ensure the budget balances.
• Once the budget is complete, all departments must adhere to the budget and execute it
accordingly
FUNCTIONAL BUDGETS AND CASH BUDGETS
Functional budgets
Functional/departmental budgets are budgets prepared for each functional area of
the company and will include production, procurement and sales.
The following example provides a comprehensive outline of such a budget:
Finished goods at 1 August 20Y8 were 500 of A and 400 units of B and the Company plans to
hold inventories at 31 July 20Y9 of 200 units of A and 300 of B.
Inventories of raw material are 800 kg of X at 1 August 20Y8 and 600kg of Y. The company
plans to hold 800 kilograms and 700 litres and respectively at 31 July 20Y9.
Provision should be made for damages and deterioration as suggested by the warehouse and
stores managers, as follows.
Required:
Prepare a material purchases budget for the year 20X8.
Cash budget
A cash budget assists management in making forward planning decisions that may be
needed, such as strengthening the credit control procedures of the organisation to
ensure that customers are paying promptly, advising banks on the estimated overdraft
requirements of the organisation.
The cash budget is an important planning tool for the organisation and reveals the cash
effects within the budgetary process, hence in the preparation process modifications are
made to the budget, if it shows that the planned operations cannot be financed due to
insufficient resources.
Cash budget
Cash budget gives management an opportunity to identify and take action on potential
problems that could arise.
Management can take appropriate action based on the four positions that the cash
budget will show.
Example
Preparing cash budgets
A company wishes to plot the cash position of the business during the three months period
June to August 20x6. A cash budget was drafted as follows:
Jun R Jul R Aug R
cash receipts
from accounts receivables (debtors) 13 000 13 500 15 000
cash sales 2 000 3 000 2 500
proceeds on disposal of non-current assets 2 200
total cash receipts 15 000 18 700 17 500
estimated cash payables
suppliers of goods 7 000 6 800 9 500
wages 2 000 2 500 2 500
purchase of non–current assets 15 000
rent and rates 1 000
other overheads 1 200 1 200 1 200
repayment of loan 1 500
11 700 25 500 14 200
net surplus / (deficit) for month 3 300 (6 800) 3 300
opening cash balance 1 300 4 600 (2 200)
closing cash balance 4 600 (2 200) 1 100
At the beginning of the budget period 1 June the accounts department calculated the
opening cash balance of R1 300.00. Cash which the organisation is likely to receive has
been estimated from credit and cash sales and disposal of non-current assets in the month
of July.
Similarly, estimates of cash due to be paid out of the business have been made. These
include payments for a planned purchase of non-current assets in July and a loan
repayment due in June, payment for lunch, rent, rates and other overheads.
The excess of cash receipts over cash payments is estimated in each month. In certain
months there will be a deficit when the cash payments exceed the cash receipts – in the
example this occurs in July, because of the huge investments the company made in non-
current assets in that month.
A cash surplus of R3 300 is generated in June, which opened with a cash balance of R 1 300.
The closing balance in June of R4 600 became the opening balance in July. July threw the
business into an overdraft with a deficit of R6 800.
The overdrawn balance of R2 200 became the opening balance for the month of Aug. The
cash surplus of R3 300 in Aug left the business at the end of the period with a favourable cash
position of R1 100.00.
Activity
Consider the items listed below and indicate, which items will be included in a
cash budget or not:
• Cash sales from the selling of merchandise
• Goods sold to Company Z on credit
• Purchased a new delivery vehicle from XYZ Motors and paid by EFT
• Written off annual depreciation on vehicles
• Charge a debtor interest on an outstanding account
• Paid the bank a monthly service fee
Example
Cash budgets
Mr M is an accountant. During the recent recession his company had to retrench some staff
members; he is one of them. He is planning to venture into business using the R30 000 he
got from his fixed deposit. He is not sure how the business will affect his cash position and
wants an input from you:
• He needs equipment and fixtures costing R20 000. The payments will be made at the
end of December and they have a 5-year life with no scarp value. R10 000 is banked as
working capital in the bank.
• On 1 January he will buy stock costing R6 000, to be paid for before the end of January
and he will be making subsequent monthly purchases at a level sufficient to replace
forecast sales for the month.
Example
• Forecast monthly sales are R9 000 for January, R18 000 for February and March, and
R31 500 from April 20X1 onwards. Customers will pay in the month following month of
purchase
• Selling price will be cost plus 50%. Suppliers of stock will be paid in the month of
purchase.
• General expenses are estimated at R4 800, which includes rent, but excludes
depreciation.
• Monthly cash drawing of R3 000 will be made by Mr M.
Required:
Prepare Mr M’s cash budget for the six months to 30th June 20X1
Solution:
• Mr M’s opening cash balance will be R10 000, after making a purchase of R20 000
for equipment in December out of the initial amount of R30 000.
• Cash receipts from credit customers arise two months after the relevant sales.
• Cost of sales is 100/150 x sales
• October cost of sales is 100/150 x R 9 000 = R 6 000.
• These goods will be sold in January but not paid for until February. Similar
calculations can be made for later months.
• Stock bought in January at a cost of R6 000 is paid for in January.
• Depreciation is not included in the cash budget as it is a notional expense.
• The cash budget can now be constructed.
MASTER BUDGET
Master budget example
The master budget is an aggregate of all level budgets prepared by all departments.
All functional budgets are consolidated to prepare the budgeted income statement and
budgeted statement of financial position.
The preparation of the income statement and statement of financial position both forms
part of the master budget because the business may wish to forecast its cash position the
company would want to project its financial position for the coming periods.
The master budget will comprise the following items, but is not limited to only
these:
• Sales budget
• Material requirements budget
• Labour budget
• General expenses budget
• General overhead budget
• Capital expenditure budgets
• Logistics budget
The master budget will comprise the following items, but is not limited to only
these:
• Marketing budget
• Finance budgets
• Administration budget
• Production budget.
• Generally, the departmental heads of each functional unit will prepare their
departmental budgets which are then incorporated in the master budget.
Example
Budgeted Statement of comprehensive income and Statement of financial positioning.
Using the information in the cash budget of the previous example, prepare a
budgeted statement of comprehensive income and statement of financial positioning
for the six months ending on 31 March 20X4.
Solution:
Forecast comprehensive income statement
For the 6 months ending 30th June 20X1
The following items will be recorded in the statement of financial position as
follows:
a) The initial purchases amount of R6 000 will comprise of the inventory.
b) Debtors will be for the previous month to be collected following month.
c) Bank is over drawn by R21 800, calculated in the cash budget.
Statement of financial position
Forecast as at 30 June 20X1
OTHER APPROACHES TO BUDGETING
Zero-based budgeting
Zero-based budgets, as the name implies, are always prepared from zero. The
assumption is that no item of expenditure is on the budget unless it can be justified.
Previous budgets are not considered, as every item of expenditure has to be
justified. This type of budgets is advisable for the marketing department and in non-
profit organisations.
OTHER APPROACHES TO BUDGETING
Rolling budgets
A rolling budget is a budget that keeps being rolled up. As a period ends, another
period is added to keep it rolling, for example a twelve-month budget running from
January to December, would be rolled up in February to add January of the next
year. This type of budget is advisable where there is little volatility in operations and
the major cause of differences is inflation.
Beyond budgeting
Managers are a given a greater degree of autonomy to make and decide on the budget.
Responsibilities are clearly defined. Managers are given objectives and clear targets to
achieve and the yardsticks to be used, are agreed upon. The managers are allowed to
decide on the budget. The goals must be adding value to shareholder wealth. The idea is
that staff at operations know the requirements in long-term value creation and not short-
term measures of performance. It normally extends over long periods of time.
Incremental budgeting
An incremental budget is a budget that increases as agreed upon.
The organisation simply adds a reasonable amount to the current budget, for example,
using the rate of inflation as a good average. Most budgets are prepared on this basis
and the annual salary increments in organisations are based on this idea.
This type of budgeting is advisable in times when the economy is not volatile and
inflation-linked increments would be appropriate.
Participative budgeting
Participative budgeting, as the name implies, requires the participation of users of the
budget. Traditionally budgets are set by top management and the lower-
level staff have almost no input. This type of budgeting tries to achieve a position
where the budget is set by the users and it easily allows the buy-in from staff for
achieving targets. This type of budgeting may be used in accounting firms or law
firms, where the staff understand the operations and are able to take responsibility.
Question
Cash-flow budget
Company D has appointed you as a consultant to prepare a cash budget for the period
ending 31 March 201X. The following projections have been made for the next three
months:
Additional information:
• 70% of the sales are collected at the end of the month of the sale and the
balance the following month. Credit sales in December 200X amount to R30 000.
• 20% of the purchases are paid at the end of the month of purchase, 60% in the
second month and the balance the following month. Credit purchases amount to
R10 000 and R12 000 respectively in November and December 200X.
• Salaries per month, R10 000, are paid at the end of the month.
• Advertising per month, R2 500, is paid at the end of the month.
Company D will commence business with a bank balance of R10 000.
Required:
Draw up the forecast cash flow forecast for the three months ended January to
March 201X using the template provided.
Practice Questions
• Do questions 5 & 6 of the practice questions
Thank You
