Budgets and planning

Syllabus points

• Explain the purposes of budgeting.
• Prepare sales, production, materials purchases, labour and cash budgets.
• Explain the relationships between the functional budgets and the master budget.

Why businesses budget

A budget is a plan expressed in financial terms for a future period. The purposes are usually remembered as planning, coordination, communication, motivation, control and evaluation.

• Planning forces managers to think ahead rather than react.
• Coordination makes the departments fit together, so production does not build what sales cannot sell.
• Communication tells each manager what is expected.
• Motivation gives a target to work towards, if it is realistic.
• Control provides the standard that actual results are compared against.
• Evaluation of managers and of the business rests on that comparison.

A budget is not a forecast. A forecast says what is likely to happen; a budget says what the business intends to make happen, and someone is accountable for it.

The order the budgets are built in

The principal budget factor, also called the limiting factor, is whatever constrains the business most, and the budget process starts with it. Usually that is sales demand, so the sales budget comes first. If the constraint were a scarce material or machine capacity, that budget would come first instead.

Everything then follows in sequence, and each budget feeds the next:

Sales budget, then production budget, then the materials, labour and overhead budgets, then the cash budget, then the master budget.

The master budget is the budgeted income statement, statement of financial position and cash budget together. It is the output of the process, not an input.

Production budget

Production is not the same as sales, because inventory absorbs the difference.

production units = sales units + closing inventory of finished goods − opening inventory of finished goods

Sales are budgeted at 9 000 units. Opening finished goods are 800 units and closing inventory is to be 1 100.

Production is 9 000 plus 1 100 less 800, which is 9 300 units.

The direction is the point. Building inventory up means producing more than is sold; running it down means producing less.

Materials purchases budget

The same logic runs one stage further back, in two steps.

First, materials required for production = production units x kilograms per unit.

Then, materials to purchase = materials required + closing inventory of materials − opening inventory of materials.

Each of the 9 300 units needs 3 kg. Materials required are 27 900 kg. Opening raw material inventory is 2 000 kg and closing is to be 3 500 kg.

Purchases are 27 900 plus 3 500 less 2 000, which is 29 400 kg. At $4 a kilogram that is a purchases budget of $117 600.

Applying the inventory adjustment to sales rather than to production, or skipping the first step altogether, is the standard error here.

Labour budget

labour hours required = production units x hours per unit

Then multiply by the rate per hour. Compare the hours needed with the hours available: if they exceed capacity, either overtime is budgeted or the production budget must be revised, and saying so is worth a mark.

Cash budget

The cash budget is a month-by-month statement of receipts and payments, and it is the most examined of all the functional budgets.

The rule that decides most of the marks is that a cash budget records cash movements when they happen, not income and expenses when they arise. Two consequences:

• Credit sales appear in the month the cash is received, not the month of sale. If customers pay in the month after sale, January's sales are February's receipts.
• Purchases appear when paid, on the same logic.

And four items are excluded entirely because no cash moves:

• Depreciation.
• Irrecoverable debts written off, and any movement in the allowance.
• Profit or loss on disposal. Only the actual proceeds go in.
• Accruals and prepayments as such. Enter the cash actually paid.

The layout is opening balance, plus receipts, less payments, giving the closing balance, which becomes the next month's opening balance.

February closes overdrawn, and that is exactly what the budget is for: the business now knows in advance to arrange an overdraft, delay a payment, or chase receivables harder.

Advantages and drawbacks

Budgeting improves planning and control, coordinates departments, gives early warning of cash shortages, and provides a yardstick for performance.

Against that: it takes management time and costs money; targets set too high demotivate and targets set too low waste capacity; a budget based on poor estimates is worthless; managers may spend up to their allowance to protect next year's budget; and rigid adherence can stop a business responding to a change in conditions.

Common mistakes

• Preparing budgets in the wrong order, or starting somewhere other than the principal budget factor.
• Adding opening inventory and deducting closing inventory in the production budget.
• Forgetting to convert production units into kilograms before adjusting for materials inventory.
• Putting sales in the cash budget in the month of sale.
• Including depreciation in the cash budget.
• Treating the master budget as an input to the process.
• Saying the cash budget shows profit. It shows liquidity.