Budgeting-Different Approaches and Uses - Term Paper Example

Running head: Budget Budgeting-Different Approaches and Uses ___________ ________________________ ________________ Budgeting-Different Approaches and Uses Introduction This paper has the primary objective to trace the various steps involved in the preparation of various kinds of budgets. Budgets are blue prints of business plans irrespective of the scale of the business. Budgets are vision statements and target boards for the course which significant stakeholders expect their organization to take in the time to come; though budgets often get on the paper via media the hands of specialists. Time horizon involved in budgeting normally varies from a single year to even decades. The most popular variety, however, remains the annual budgets. Budgets due to their inherent capabilities in putting the entire business plan on paper and with an ongoing check on progress inbuilt are prepared not just by organizations seeking profits; very many non-profits outfits and organizations working as expenditure centers also prepare budgets. Often for a commercial organization which is both a manufacturer and seller budgets envelope all activities and in the discussions taken up in this paper only such organizations would be cited. Due to their important lighthouse role to the business ships targeting to shore a decent profit mechanics of preparing various categories of budgets and their importance for decision making managers assumes importance. This paper covers these two aspects primarily, taking adequate precaution to explain in detail, encourse, the important categories of budgets. Process of Budgeting Budgets are drawn to assist in clarifying and attaining business objectives. These objectives can be varied but can be commonly listed as minimizing costs/controlling expenditures, increasing revenues, gaining a higher market share, improving spread/margins (through increased sales), etc. Therefore, a statement of identified objectives becomes important at the commencement of budgeting. Once these objectives have been set then the rest of the budget can fan out after a series of logical coordination. Subsequent to the statement of identified business objectives and determination of the budget period (say 1 week, 1 fortnight, 1 month, 1 year, etc), additional information need to be gathered in order to compile the budget. This information generally includes past and current performance data procured from profit and loss accounts, balance sheets and previous cash flow forecasts of the organization. In case of a new business peer studies can be important guide posts. To help new concerns, good amount of classified data is published by various industry associations. Irrespective of the context this information can then be used to identify probable sales in number of units and associated costs in the future. One approach to budgeting is to compile from scratch ignoring all previous historical data and current performance: this is termed as zero-based budgeting which can be risk prone and should be taken up by those who have very realistic estimates of strengths of their concern vis a' vis market demands. It is commonly observed that during the preparation of budgets certain figures are easier to state with confidence than others. For instance, costs fall in former category while predicting sales falls in the latter category. The obvious reason for this is the fact that sales are affected by several probable factors (e.g. increase or decrease in demand, level of competition, changes in consumption pattern,technology,fashions,fads etc);while costs are technically stated and determined by suppliers/government policies and remain relatively stable.However,these are to be stated preferably on some historical and comparable base. This paper would exhibit subsequently important functional budgets that follow from statement of sales and cost objectives; however two important points need emphasis in respect to the process of budgeting-one, ideally the budgeting should be grass root budgeting that is, not only should all the staff, including lowest rung, be involved in actual budgeting process by actively contributing to target setting but, two, the budgeting should also be accountable budgeting in the sense that maximum number of staff should be tied up in accountable positions vis a vis the targets they helped in setting up. While most budgeting is done on an annual time horizon and runs parallel to the financial year; it must be ensured that budgeting for the next financial year commences at least a quarter in advance of the commencement of the year. When budget are formed on an annual scale, it is better for the budget to be split into monthly statements to make the process more manageable and feasible to follow. Many concerns go as far as to budget on a 1-4 week cycle, but to be truly forward looking some time-cushion is necessary for requisite plan setting. Preferably budgeting should be done by specialists. It may be remembered that as concerns grow, the span of control of business owners/stakeholders reduces significantly. Budgeting perks up this span of control by setting up targets to increase profits and performance. In fact any concern is targeting its Return on Investment (ROI) through budgeting. Budgeting for your small business gives you control over your finances (Campbell, 2005).Consequently, budgeting enables thinking ahead in order to control the management of the concern. A model budgeting process is shown at Annexure A. Sales Budget Sales budget is normally the first of all budgets to be compiled. The reason for this is fairly straight forward viz.All other budgets would be based on this and limited by this budget. As an instance, DGP Ltd is expecting (budgeting) the following sales revenue in the next three months. () April May June Chocolates 60000 60000 70000 Lollipops 45000 50000 60000 Candies 40000 35000 30000 The above figures are those of sales revenue which will need to be calculated by multiplying the expected number of unit sales by the selling price of the product. An important distinction can be brought about here you can either recon sales revenue on current prices or factor in a degree of inflation; the latter budgeting would take care of inflation. Order book of the business can be relied upon to ascertain future orders from existing customers to which a comfortable number of new customers with average orders can be added to get the sales in units. If trade terms afford credit to customers, it is important that all credit sales should be placed in the month of realization and not the month of sale. This example of goods sales can be extended easily to sale of a service. Production Budget For an organization offering services production budget is called an Operating Budget. The production budget is compiled with the objective that the business will meet the expected sales on an ongoing basis. This budget uses stock flow approach and is, therefore, compiled using unit numbers instead of financial figures. Depending upon the number of products/services offered by the concern the production budget is set up for each products/services. Illustration carried below assumes just one product: (No. of Units) April May June Opening Stock 20000 0 5000 + Units Produced 20000 40000 40000 Less Units Sold* 40000 35000 30000 Closing Stock 0 5000 15000 *It may be observed that units sold correspond to sales of candies @ 1 per candy in the Sales budget. Thus production budget is used to state the number of units to be manufactured (or procured from suppliers) so that demand can be met (as identified in the relative sales budget). This takes care of undulating stocks and demands as well-building in seasonality and other factors. Idea is not to tie up working capital finance in building up inventory that cannot be sold for long. As such finance is expensive. In case high demand, exceeding manufacturing capacity, is expected during certain month(s) then inventory needs to be built up from those months when utilization of plant is below par. For those concerns that have high demands through out it may be a signal to buy/hire more machinery/staff in that particular month to allow an increased capacity for production. Materials Purchase Budget This budget is prepared by manufacturing concerns and carries the units of raw materials to be purchased, to support production, multiplied by their respective prices. Objective is to reduce the amounts indicated in these budgets by looking for cheap suppliers and bulk suppliers. Staff Budget This budget states the number of staff required to carry on with the manufacturing, selling and administrative activities and places in monetary terms their salary bills, perks, bonuses, insurance, health, pension payments etc in staff cost budget. Overheads Budget In manufacturing concerns overheads form a proportion of total expenditures. Overhead budgeting can be done either by allocating a fixed proportion to each line/product (preferably based on its overall contribution to business) or in one budget covering all overhead costs -item wise. Capital Expenditure Budget As observed above additional production capacity may be required depending upon the sales budget. This additional capacity can be purchased or hired. Capital expenditure budget states the expenditures to be incurred on such capacity enhancement and maintenance. Uses of Budgets for Managers After an operational budgeted period has run through, it is very probable that budgeted figures will vary from those obtained actually at end of period. This may be caused due to calculation errors, changes in plan, or entirely due to external factors out of concern's control such as change in government policy, fashion &style changes etc. These differences are called variances. These variances are the most effective tool in following up on the budgets and throw up material for numerous business decisions.Therefore,upon first sighting variances should not be ignored but acted upon immediately, even if they are positive. These variances are calculated simply by: if the actual figure is more favourable than the budgeted figure, it is often reported with letters fav (favourable). Similarly, if the actual figure is worse than the budgeted figure, it is reported with letters adv (adverse). When we look at variances, we are trying to establish the difference between what has actually happened (what we did achieve) and what we thought should have happened, namely the original budget (what we should have achieved).(Newman,2002)Small variances (impacting cash flows in minor fashion) can be set aside. Such variances can occur invariably. For significant variances, affecting cash flows negatively, investigations should be carried out at once, else it may be too late and causes will snowball into sickness. When you are calculating your variances, take materiality into consideration. (Spafford, 2003) This would bring about causes, uncover responsibilities, and prevent recurrence through appropriate policy. . For instance, it may be found that overheads are shooting up in an unreported faulty machine which is also affecting output quality and sales. This may necessitate immediate managerial decisions on production lines and in markets (withdraw low quality output etc). If the variance is significantly favourable, investigation may lead to policy to profits in terms of making such factors regular. Thus variance analysis itself is an area rife with material for very effective managerial decisions. References Campbell, Melody. (2005).Does my small business need a budget Retrieved on August 8, 2006 from http://articles.simplysearch4it.com/article/10246.html Newman, Angela. (2002). Variance analysis. Retrieved on August 8, 2006 from http://www.accaglobal.com/publications/studentaccountant/256576 Spafford, George. (2003). The Power of Variance Analysis. Retrieved on August 8, 2006 from http://www.gantthead.com/article.cfmID=177431 Annexure A 1. Review last year's budget and prepare a list of changes needed in operations or the budgeting process based on differences between actual and projected amounts. 2. Calculate return on investment (ROI) for the last year. Determine a realistic ROI goal for the next year. 3. Estimate changes in expenses for the next year. 4. Calculate the revenues needed to meet the ROI goals and anticipated expenses. 5. Evaluate how attainable the revenue goals are. 6. Readjust expense and ROI projections so that revenue goals are achievable. 7. Monitor budget income and expense categories monthly, comparing actual to budgeted figures so that significant variances can be cared for immediately. Read More