Managing Finance _ Budgets

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					Managing Finance and Budgets
           Lecture 9
          Budgets (1)
               Session 9 – Budgets (1)

                   LEARNING OUTCOMES
   To understand the importance and role of budgets in
    organisations
   To understand the processes involved in the setting and
    monitoring of budgets
                      Key Concepts

   Budget definitions and purpose
   The budget-setting process
   Types of budget
   Section A:

What are Budgets?
              Budgets - definitions

“A plan, qualified in money terms, prepared and approved
  prior to a defined period of time, usually showing planned
 income to be generated and/or expenditure to be incurred
     during that period, and the capital to be employed to
                     attain given objectives”

                    (CIMA definition)
           What exactly is a Budget?
A budget:
• Predicts the contribution to income which will be expected
  to be generated by each department and each project.
• Allocates to each department, project or activity an
  appropriate share of the of funding in order to enable that
  income to be generated.
         What exactly is Budget for?
A budget:
• enables a business to plan appropriately for the future
• Important tool for management agenda-setting and
  control
• sets targets in monetary terms for departments and
  projects
• provides a way of sharing out resources to departments
  and projects so that they can have continued existence.
This example budget shows how
we set targets, allocate money,
make predictions and set targets.   Example of a Cash Budget
Receipts (£000)           Jan       Feb   Mar   Apr   May   Jun
Debtors                   60        60    55    45    50    50
Cash Sales                10        10     5    15    10    10
Total                     70        70    60    60    60    60
Payments (£000)           Jan       Feb   Mar   Apr   May   Jun
Creditors                 30        30    35    25    30    30
Salaries                  10        10    10    10    10    10
Electricity                               15                15
Other overheads            5         5     5     5     5     5
Loan repayments           15        15    15    15    15    15
Total payments            60        60    80    55    60    75
Cash-flow                 10+       10+   20-   5+    -     15-
Opening Balance           20        30    40    20    25    25
Closing Balance           30        40    20    25    25    10
These are predictions about the
cash inflow . These will become
monthly targets for sales and for
debt collection.
                                    Example of a Cash Budget
Receipts (£000)           Jan       Feb   Mar   Apr   May   Jun
Debtors                   60        60    55    45    50    50
Cash Sales                10        10     5    15    10    10
Total                     70        70    60    60    60    60
Payments (£000)           Jan       Feb   Mar   Apr   May   Jun
Creditors                 30        30    35    25    30    30
Salaries                  10        10    10    10    10    10
Electricity                               15                15
Other overheads            5         5     5     5     5     5
Loan repayments           15        15    15    15    15    15
Total payments            60        60    80    55    60    75
Cash-flow                 10+       10+   20-   5+    -     15-
Opening Balance           20        30    40    20    25    25
Closing Balance           30        40    20    25    25    10
These are predictions about the
cash outflow . Most of these are
fixed and will be paid at the times
stated.
                                      Example of a Cash Budget
Receipts (£000)            Jan        Feb   Mar   Apr   May   Jun
Debtors                    60         60    55    45    50    50
Cash Sales                 10         10     5    15    10    10
Total                      70         70    60    60    60    60
Payments (£000)            Jan        Feb   Mar   Apr   May   Jun
Creditors                  30         30    35    25    30    30
Salaries                   10         10    10    10    10    10
Electricity                                 15                15
Other overheads             5          5     5     5     5     5
Loan repayments            15         15    15    15    15    15
Total payments             60         60    80    55    60    75
Cash-flow                  10+        10+   20-   5+    -     15-
Opening Balance            20         30    40    20    25    25
Closing Balance            30         40    20    25    25    10
This is our predicted monthly cash
inflow/outflow. We can use this to
detect peaks and troughs             Example of a Cash Budget
Receipts (£000)           Jan        Feb   Mar   Apr   May   Jun
Debtors                   60         60    55    45    50    50
Cash Sales                10         10     5    15    10    10
Total                     70         70    60    60    60    60
Payments (£000)           Jan        Feb   Mar   Apr   May   Jun
Creditors                 30         30    35    25    30    30
Salaries                  10         10    10    10    10    10
Electricity                                15                15
Other overheads            5          5     5     5     5     5
Loan repayments           15         15    15    15    15    15
Total payments            60         60    80    55    60    75
Cash-flow                 10+        10+   20-   5+    -     15-
Opening Balance           20         30    40    20    25    25
Closing Balance           30         40    20    25    25    10
Finally we can monitor the cash
balance on a month by month
basis. We can predict for example
where overdrafts are needed.
                                    Example of a Cash Budget
Receipts (£000)          Jan        Feb   Mar   Apr   May   Jun
Debtors                  60         60    55    45    50    50
Cash Sales               10         10     5    15    10    10
Total                    70         70    60    60    60    60
Payments (£000)          Jan        Feb   Mar   Apr   May   Jun
Creditors                30         30    35    25    30    30
Salaries                 10         10    10    10    10    10
Electricity                               15                15
Other overheads           5          5     5     5     5     5
Loan repayments          15         15    15    15    15    15
Total payments           60         60    80    55    60    75
Cash-flow                10+        10+   20-   5+    -     15-
Opening Balance          20         30    40    20    25    25
Closing Balance          30         40    20    25    25    10
The uses of budgets


  Five areas of usefulness:



   Forward planning



    Co-ordination



      Motivation



       Control



    Authorisation
                    Budgets - Purpose

   Encouraging forward planning and identifying any
    possible future problems to enable solutions to be
    implemented in advance
   Ensuring co-ordination across the organisation so that
    all departments are able to fulfil organisational objectives
   Motivating managers to improved performance against
    set benchmarks
   Providing a basis for control systems
   Providing a basis for a system of authorisation, so that
    managers know exactly what are the limits to their
    authority, manage within them.
      Section B:

How are Budgets Created?
              How are Budgets created?

   The budget-setting process is quite complex, and often
    very time-consuming.
   It involves a number of stages, some of which ask the
    business to question precisely what it is doing, and where
    it is going – almost at a „philosophical' level
   Other stages involve detailed calculations of amounts of
    money and negotiations about who gets what.
   A complex budget may take six months to one year to
    produce.
                      Budget Setting

   This is often an annual process linked to a review of long-
    term plans – Planning & Control
   It is an iterative process. Tentative plans are created,
    which are thrown open to discussion. These discussions
    then lead to modifications and further discussion, and so
    on until the budget is set.
   Should be participative – all interested parties involved,
    with the process „transparent‟.
   A combination of top-down(i.e. agenda-setting) and
    bottom-up (i.e. recognition of needs) approaches is
    required.
The Planning & Control Process

      1.Identify business objectives

       2. Identify available options

      3. Evaluate and select options

   4. Prepare detailed plans or budgets

  5a.Collect information on performance

   5b. Identify and respond to variances

      5c. Revise Plans if necessary
        1. Identifying Business Objectives

• Business Aims and Objectives are normally encapsulated
  in a Mission Statement. Such statements often aspire to
  ideals:
   • Liverpool Hope University College aspires to: “educate
     students in mind, body and spirit”
   • Railtrack plc has a vision of : “a safe, reliable, efficient
     and modern railway”
• On the other hand, some companies take an altogether
  more pragmatic view.
   • Cadbury Schweppes plc has a mission statement
     committed to: “..growth in shareholder value”
       1. Identifying Business Objectives

• Objectives are normally more specific than the aims.
• These vary, but will include consideration of such things
  as:
   • The kind of market the business seeks to serve
   • The market share it aspires to
   • The level of operating efficiency
   • The kind of product it offers
   • The level of growth to be attained
   • The level of profit required
• These objectives should be quantifiable and be consistent
  with the Mission statement.
          2. Identifying Available Options

•   To achieve the business objectives, a number of
    strategies may be available.
•   In order to uncover these, information will need to be
    collected,
•   This process may be time-consuming
•   The information will include
     • an analysis of the external competitive environment,
     • and an analysis of the internal resources and
       capabilities of the business
         2. Identifying Available Options

External considerations might include:
• Market size, growth
• Level of competition
• Threat of newcomers
• Relative powers of trades unions, interest groups etc.
Internal Considerations might include:
• Culture within the organisation
• Marketing, distribution issues
• Manufacturing capability
• Finance and administration
• Research & Development
• Human Resource Management
       3. Evaluating and Selecting Options


•   During the evaluation phase, Managers must examine the
    available information on each option to determine which
    one most closely fits with the objectives that have
    previously been set.
•   NB Research suggests that too much information may
    produce „information overload‟, where managers become
    confused and distracted by irrelevant data.
•   Sometimes this is called „paralysis by analysis‟.
       3. Evaluating and Selecting Options


•   During the selection phase, the options chosen will form
    the basis of the long-term plan
•   These options will specify things such as:
     • Products or service to be offered
     • Sources of finance and the amounts
     • Capital investments
     • Personnel requirements
                 4. Setting the Budget


•   A budget is basically a short-term plan (normally one
    year) which is expressed mainly in financial terms.
•   Budgets will normally define precise targets for such
    things as:
     • Cash Receipts & Payments
     • Sales targets for each item or department
     • Stock requirements
     • Labour requirements
     • Production Levels
    5a. Collecting Information on Performance


•   Control = the process of making planned events actually
    occur.
•   Accounting is very useful in this context. Plans are set in
    accounting terms, and outcomes can be matched against
    targets.
•   Where differences occur, these are highlighted as
    variances.
5b. Responding to Information on Performance

•   Managers will be alerted to variances between the
    budgeted amounts and the actual figures.
•   Action will be needed in order to get the business on track
    towards achieving budgets.
•   For example if sales targets have not been achieved, the
    manager may need to review the sales strategy, to
    discuss alternative forms of marketing or to make
    concerted efforts to find new customers.
          5c. Revising Plans and Budgets

•   If variances continue and are not rectified, or figures are
    produced on the basis of incorrect assumptions, or
    circumstances alter, then a revised budget may need to
    be published.
•   This new budget will set different targets, and reallocate
    the remaining funds in order to respond to the new
    circumstances.
 The Planning & Control Process – a summary

                                            Mission, Aims, Objectives
1. Identify key objectives                  Market, Products, Services
                                           Sales, Costs, Profits, Returns

                                        Limiting factors: External & internal
2. Identify available options          Environment - market size, production
                                               capability, competition

3. Evaluate and select options            Markets, products, financing,
                                       physical resources, human resources


4. Prepare detailed plans or budgets   Short-term plans: Sales, Cash, Stock,
                                       Labour, Production  Master budget


5.Collect information and control         Identify variances and respond
                                                   as appropriate
                  Activity One


List the advantages and disadvantages of using budgets
in an organisation.
                  Activity One - solution

         Advantages                      Disadvantages
•   Each are of the business     •   Targets tend to be met,
    knows exactly what they          but not exceeded
    need to achieve

•   Each manager knows           •   Resources tend to be
    precisely what resources         „used up‟, even where
    are available to work with       they are not required.

•   The business can plan        •   The business finds it hard
    effectively for expansion        to respond to new
    and be proactive, not            initiatives, since the
    reactive.                        resources are already set.
         Section C:

What are the different types of
          Budget?
              Budgets – Time horizons

Periodic budget
 This is a one-off budget set for a year (e.g.)
 It is normally broken down into monthly or weekly
  amounts
Continual Budget
 This will be updated continually (still for one year, but a
  new month will be added to replace the one which has
  passed.)
                 Budgeting Principles

Incremental budgeting
 This is a method of budgeting based on what happened
  last year, but with alo9owance for factors such as inflation
  (e.g if spending was £8,000 last year, we might increase it
  to £8,250 this year.)
Zero-Base Budgeting
 This rests on the philosophy that all spending needs to be
  justified; there can be no „carry over‟. Managers will need
  to be convinced that each activity represents „value for
  money‟.
                   Types of budget

   Cash budget
   Stock budget
   Debtors budget
   Creditors budget
   Income & Expenditure budget
   Capital budget
   Discretionary budget
   Master budget
              Cash Budget - Example
Receipts (£000)   Jan   Feb   Mar   Apr   May   Jun
Debtors           60    60    55    45    50    50
Cash Sales        10    10     5    15    10    10
Total             70    70    60    60    60    60
Payments (£000)   Jan   Feb   Mar   Apr   May   Jun
Creditors         30    30    35    25    30    30
Salaries          10    10    10    10    10    10
Electricity                   15                15
Other overheads    5     5     5     5     5     5
Loan repayments   15    15    15    15    15    15
Total payments    60    60    80    55    60    75
Cash-flow         10+   10+   20-   5+    -     15-
Opening Balance   20    30    40    20    25    25
Closing Balance   30    40    20    25    25    10
       Stock & Debtors Budgets - Example
Stock                 Jan     Feb       Mar     Apr      May    Jun
Opening Balance         0     20        50      40        30    20
+ Purchases/Production 30     60        50      20        20    50
- Usage                10     30        60      30        30    60
Closing Balance        20     50        40      30        20    10
              May be calculated in units (by product) or in £
Debtors               Jan     Feb       Mar     Apr      May    Jun
Opening Balance         0     20        50      40        30    20
+ Sales                30     60        50      20        20    50
- Cash received       10      30        60      30        30    60
Closing Balance        20     50        40      30        20    10
           Creditors Budgets - Example
Creditors         Jan   Feb   Mar   Apr   May   Jun
Opening Balance    0    20    50    40    30    20
+ Purchases       30    60    50    20    20    50
- Payments made   10    30    60    30    30    60
Closing Balance   20    50    40    30    20    10
   Income & Expenditure Budget - Example
                     Jan    Feb   Mar   Apr   May   Jun
Sales                100    120   150   140   130   120
Direct Costs
 Materials            40    48    60    56    52     48
 Labour               20    24    30    28    26     24
Total Direct Costs    60    72    90    84    78     72
Gross Profit          40    48    60    56    52     48
Overheads
Admin Salaries        20    20    20    20    20     20
Travel                 5     5     5     5     5      5
Other costs           20    20    20    20    20     20
Total Overheads       45    45    45    45    45     45
Net Profit            (5)    3    15    11     7      3
Cumulative            (5)   (2)   13    24    31     34
                      Preparation of budgets in SMEs
           Source: Chittenden, F., Poutziouris, P., and Michaelis, N. Financial
               management and working capital practices in UK SMEs,
                         Manchester Business School, 1998




     Sales budget                                                           78


Budgeted profit and loss                                               76


  Overheads budget                                                73


     Cash budget                                            63


Budgeted balance sheet                               46


  Purchases budget                        35


  Production budget                21


                           0       20           40          60                   80       100
                                                                 Frequency of preparation (%)
         Setting Complex Multiple Budgets

   Clearly, where there are a number of interlocking budgets
    to create, the process can be quite complex.
   Often departments are asked to create „spending plans‟
    (speculative, often optimistic documents, bidding for
    money and suggesting targets)
   Managers will be called to interview to justify these plans,
    and to negotiate realistic targets.
   Out of this process, draft budgets will be created, which
    will be reviewed and co-ordinated.
   Finally the master budget will be created and
    communicated.
   Steps in a complex budget setting process




 Establish responsibility for   Communicate budget guidelines
 the budget-setting process         to relevant managers


 Prepare the budget for the       Identify the key or limiting
 area of the limiting factor                 factor


Prepare draft budgets for all      Review and co-ordinate
        other areas                       budgets


Communicate the budgets to        Prepare the master budgets
   all interested parties


Monitor actual performance
  relative to the budget
                Sensitivity Analysis

This is a tool used in setting technically complex budgets:
 It investigates changes to profit due to adjustments in
   key variables
 It identifies key areas for managers to focus on for
   maximum effect
In order to use it, managers need to:
 Identify key questions to be answered – e.g. what is the
   effect on profits of 10% decrease in sales? Or a 10%
   increase in cost of sales?
 Use spreadsheets or other types of computer software in
   order to create „what-if‟ analyses.
   Thought Activity – Creating a Budget

You have hired a venue to host a touring theatre company for three
nights of performances of “Jumpers” by Tom Stoppard. You need to
prepare an Income and Expenditure Budget and a Cash Budget for
the performances. You need to allow for three income streams: ticket
sales; sale of refreshments; and programme sales.

You need to identify key questions you need to ask to enable you to
estimate your income, direct costs and indirect costs as accurately as
possible.

Having prepared a budget, you need to decide which are the
parameters you would like to vary, in order to carry out appropriate
sensitivity analysis.
        Follow-Up to Lecture Nine - Activities

   Preparation: read Chapter 12
   Describe key concepts:
        Budget definitions and purposes
        Budget-setting process
        Different types of budget
   Exercises 12.3 and 12.7

				
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