Budgeting and budgetary control

A budget is a forward financial plan. It provides a prediction of expected flows of money in and out of

the firm in the immediate future. Normally, a budget will be prepared in advance of a period of time,

usually a year but could be on a monthly or quarterly basis

Budgets are drawn up for a number of reasons within a firm. Often the process of producing a budget

will take a significant amount of time. Producing budgets on a regular basis, for a large part of the

activities of the business will help with the following:

Functions of budgets
Planning

Budgeting forces managers to plan, and therefore consider, alternative future courses of action, to

evaluate them properly and to decide on the best alternative. It also encourages managers to

anticipate problems before they arise, thus giving themselves time to consider alternative ways of

overcoming them when they do happen, and to prepare for circumstances (even simple course of

action such as prearranging a bank overdraft will be possible as part of the budgeting process).

Budgeting tends to produce better results than decisions made 'on the spot'.

Co-ordination

Without a full system of budgetary control, managers of different functions within the firm (i.e. sales,

production, finance, etc) may make decisions about the future which are in conflict with other

departments. For example, the sales department may plan an advertising campaign to boost sales to

a point beyond the productive capacity of the firm, or without the necessary finance A coordinated

budgetary system will help ensure that actions by the different departments and the different people

involved (budget holders or budget managers) will not be taken without ensuring that it fits in with

other plans.

Control

Comparisons of budgeted data and the actual data (when it occurs) is a procedure known as variance

analysis. Comparing what was expected (the budget) with what actually happened can help mangers

to control the finances in a more direct manner. If an area of the business is continually overspending,

then investigative action can be taken to see why this happening. It may not be a fault of any one in

particular but at least the areas of the business which is concerned can be identified, which will save

time. It will be harder for managers and other personnel to spend money which is not justified if there
is a system of drawing up expected outflows of cash in advance of these happening. Individual
departments can be analysed by examining what money has been either generated or spent by each

department. This helps with overall performance evaluation.

Motivation

Involving people throughout the organisation in the process of budgeting will help to bring the staff

closer together. By setting targets, staff are more likely to feel involved within the organisation and

therefore are likely to be more highly motivated. This should help boost productivity and also reduce

absenteeism and labour turnover. By delegating the budgetary control down the chain of command

(from the senior management to the junior manages and other staff), this should help boost

motivation.

Cash budgets

A cash budget, also known as a cash flow forecast, is a prediction of future cash inflows and cash

outflows over a period of time.

Cash budgets are produced by many firms and are probably the type of budget that will appear in

examination questions most frequently. Fortunately, cash budgets, with a little practice, are fairly

straightforward to produce.

Cash inflows
A cash inflow is any amount of money that the firm received. This will include, money received from

sales (either cash sales or receipts from debtors), as well as any other form of money. Any loans

taken out by the firm would also be included as a cash inflow, as would the sales of any fixed assets.

Cash outflows
A cash outflow is any money that is spent by the firm. This will involve money spent on purchases of

stocks, money spent on wages and other bills. It will also include capital expenditure on the purchases

of fixed assets, as well as loan repayments and tax payments.

Net cash flow

For any period of time, usually over a month, a firm's net cash flow can be calculated. It is the

difference between the cash inflows to the firm and the cash outflows.
The net cash flow is calculated as follows:

Net cash flow = Cash inflows - Cash outflows

Differences between cash flow and profit

Although a cash budget is fairly easy to prepare, it can be confusing to deal with after spending lots of

time focusing on the production of profit and loss accounts. This is because the principles of a cash

budget are different from those used in the production of profit and loss account.

The profit and loss account is drawn up on the accruals basis. This means that incomes are expenses

are accounted for in the period in which they are incurred not when they are paid or received. Capital

revenue and incomes are not included in the profit and loss account.

A cash budget is drawn up on the basis on cash received and cash paid. It does not matter what the

money is for, it will be included in the period the cash flow appears.

Example 1

Alec Powell is a sole trader who buys and sells electrical goods. The following sales are expected over

the six-month period from November 2005 to April 2006.

- Purchases Sales
Nov £12,000 £17,000
Dec £14,000 £22,000
Jan £13,000 £18,000
Feb £14,000 £14,000
Mar £15,000 £16,000
Apr £18,000 £18,000

 Wages are paid each month of £1,000 which are paid in month that they are incurred.

 Overhead expenses are due each month of £800 and these are paid one month in arrears.

 On 1 March 2006, a new van is purchased for £8,000. The old van is sold on 15 April for £1,500.

 Sales are all on credit and we allow a two-month credit period

 Half of the purchases are on credit - we are allowed a month credit period - and half are for
immediate settlement,

 The balance at the bank as at 31 December 2005 was £1000 (overdrawn)

 Produce a cash budget for the four-month period ending 30 April 2006.
Example 1 - answer
Alec Powell - cash budget for four months to April 30 2006

- January February March April

- £ £ £ £
Cash inflows -
Receipts from debtors 17,000 22,000 18,000 14,000
Sale of van - - - 1,500
Total cash inflows 17,000 22,000 18,000 15,500
- - - - -
Cash outflows - - - -
Cash purchases 6,500 7,000 7,500 9,000
Payments to creditors 7,000 6,500 7,000 7,500
Wages 1,000 1,000 1,000 1,000
Overheads 800 800 800 800
Purchase of van 8,000 - - -
Total cash outflows 23,300 15,300 16,300 18,300
- - - - -
Net cash flow (6,300) 6,700 1,700 (2,800)
Opening balance (1,000) (7,300) (600) 1,100
Closing balance (7,300) (600) 1,100 (1,700)

Points to note

Although the cash balance worsens over this period, we cannot say whether Powell has made a profit

or a loss. This is because, a profit and loss account would be drawn differently. For example, the

purchase of the new van, which leads to a £8,000 cash outflow, would not appear as a profit and loss

account expense (although the depreciation on this van would do so).

The closing balance for the cash balance (at the end of the month) becomes the opening balance in

the following month.

Types of budget

Just about all firms will budget for future finances. It would be expected that a firm starting out would

have to present a budgeted set of final accounts, as well as a cash budget in order to borrow money

from a bank. Sole traders are more likely to produce only one or two of the following budgets.

However, to gain from the benefits outlined above, larger firms would be expected to produce all of

the following types of budgets.

It is important to understand that each of the following budgets in merely a sub-budget (for a
particular area of the business) of the overall master budget for the firm. The different types of budget

are as follows:

 Sales budget: the expected level of sales - usually by value but could also be by sales volume
(units) as well.

 Production budget: once the level of sales has been budgeted, the expected production (in units
of output) will be set in the production budget.

 Purchases budget: once the production budget has been drawn up, the purchases budget will

then be produced - this will outline the purchases of materials and other inputs into the production
process.

 Debtors budget: this will be based on the expected level of credit sales and also, the credit

period offered by the firm to customers - it will show how much we are owed by our debtors at
any particular time

 Creditors budget: this will be based on the expected level of credit purchases and also, the

credit period offered to the firm to suppliers - it will show how much we owe our creditors at any
particular time

 Cash budget: also known as a cash flow forecast, this shows the cash inflows and cash outflows
as they occur for a period of time.

 Master budgets: this is set of budget final accounts (a budgeted profit and loss accounts and a

budgeted balance sheet). It is know as a master budget because it is based on all the other sub-
budgets.

To illustrate some of the following budgets in action we will use the following example.

Example

Will Todd produces model cars that he produces and sells to local retailers. He has decided to

produces a full set of financial budgets to help him plan ahead. The following data is available January

to July 2003.

Month Sales (number of cars)

Jan 50
Feb 60
Mar 60
Apr 80
May 100
Jun 120
Jul 150
 Each model car will be sold for £50.

 The raw materials needed for the production of each car will cost £30

 Materials are purchased in the month of production

 He obtains one month's credit from the supplier of raw materials

 He give two month credit to the retailers

 The production in each month should be organised so that the closing stock at the end of each
month is equal to the next month's sales.

 The stock as at January 1st 2003 is 30 cars

 Assume that, at the start of the year, there are no amounts owing from debtors and no amounts
owing to creditors

From this data we can produce the following budgeted examples for the six month period ending 30

June 2003. Once you have read each section, try to produce the relevant budget from these figures

and then follow the link to see how you got on.

Sales budget
A sales budget should really be based on up to date market research concerning future trends in

demand. However, many firms will simply base the future level of sales of past trends. They may

extrapolate from past data (i.e. looking at the average change in sales over the past few years as the

basis for predicting future sales). Other factors to be considered would also include:

 Forecasted changes in national income - to estimate changes in consumer spending

 Any changes in legislation, taxes or regulations expected in the future

 New competition, or changes in existing competitors actions

 Expected changes in tastes and fashions

 Seasonal factors - most products will have seasonal peaks and troughs in sales

The sales budget will be calculated on the expected sales volume (sales in units) and the selling price

of each unit, to give us the overall sales value expected. Of course, any change in price may also have

the additional effect on the level of sales volume.

Production budgets
Once the sales level has been budgeted for, the other budgets can then be generated as a result. This

will involve constructing budgets for production, for purchases of raw materials, as well as for cash.

The production budget will follow on from the sales budget and will specify when and how many units

will need to be produced to satisfy the sales level forecasted - note that the production budget is

presented in units rather than in financial terms. If production is a lengthy process, then it is

important that the budget is accurate so that sales are not lost because of inadequate levels of output.

For each month the production required will equal the sales, plus the desired closing stock, less the

opening stock. For example, at the start of January we had 30 cars in stock, we expected to sell 80

during January, and we should have 60 left at the end of the month (for February's sales). Therefore

production for January would be 80 + 60 - 30 = 110 cars.

Remember:

Opening stock + production - sales = closing stock

Therefore production for each month will be equal to: Sales + closing stock - opening stock

All this is saying is that you must produce enough so that you can satisfy your requirements for how

much closing stock you require, plus the sales that you will generated in that month, not forgetting

that you already have some stocks available from the previous month

Purchases budget
Once the production budget has been finalised, the firm will know exactly how many units of materials

and other inputs will be need to be purchased. The purchases budget is simply an expression of the

production budget but in financial terms. Although it is possible that some purchases will be made in

the period before the production takes place.

Debtors budget
The debtor's budget shows the balance owed to the firm by the debtors of the firm. This will be

determined by:

 Level of credit sales

 Length of credit period offered.

Once, the sales budget has been produced, if the firm's credit policy has been decided, then the

debtors budget can be produced.

Creditors budget
Once the level of purchases has been decided (which will comes from the production budget, which, in

turn, comes from the sales budget). The firm will then be able to draw up the creditors budget. This

budget outlines how much at any time is owed to the suppliers of the firm

Master budget

A master budget is the term used to describe a budgeted profit and loss account and a budgeted

balance sheet. Although it is a budget, and has not actually happened, it is still drawn up using the

same principles as a profit and loss account and a balance sheet that are based on actual data.

The data used to construct the cash budget can also be used to produce the master budget, This can

cause confusion - switching from one technique to the other.

Example 1

M Gibb - balance sheet as at 31 December 2007

- £ £ £
Fixed assets - - 50,000
Premises - - -
Equipment - 20,000 -
Less deprecation - 14,000 6,000
- - - 56,000
Current assets - - -
Stock 5,500 - -
Debtors 11,000 - -
Cash at bank 4,750 21,250 -
- - - -
Current liabilities - - -
Creditors - 9,000 -
- - - -
Working capital - - 12,250
- - - -
Net assets - - 68,250
- - - -
Financed by: - - -
Capital - - 50,000
Add net profit - - 25,000
- - - 75,000
Less Drawings - - 6,750
- - - 68,250

Additional information:

1. Sales and purchases are all on credit - with one month's credit being allowed by us and by our

suppliers.

2. Expected sales and purchases are as follows:

- Jan Feb Mar Apr May Jun

Sales (£) 15,000 24,000 29,000 34,000 34,000 36,000
Purchases (£) 12,000 18,000 20,000 26,000 28,000 35,000

3. The owner takes personal cash drawings each month of £500

4. Wages and salaries amount to £2,400 each month

5. Insurance of £100 is paid each month

6. Overheads are £300 per month and are paid when they are due.

7. New equipment is purchased on 1 March 2007 for £6,000

8. Equipment is to be depreciated at 10% on cost - one month's ownership equal's one month's

depreciation.

9. Rent is received of £400 each quarter on 1 January and 1 April.

10. Stock in trade on 30 June 2007 was valued at £5,700

=Example 1 - answer
M Gibb - cash budget for six months ended 30 June 2007

- Jan Feb Mar Apr May Jun

- £ £ £ £ £ £
Cash inflows -
Receipts from debtors 11,000 15,000 24,000 29,000 34,000 34,000
Rent received 400 - - 400 - -
Total inflows 11,400 15,000 24,000 29,400 34,000 34,000
Cash outflows -
Payments to creditors 9,000 12,000 18,000 20,000 26,000 28,000
Wages & Salaries 2,400 2,400 2,400 2,400 2,400 2,400
Insurance 100 100 100 100 100 100
Overheads 300 300 300 300 300 300
Drawings 500 500 500 500 500 500
Equipment - - 6,000 - - -
Total outflows 12,300 15,300 27,300 23,300 29,300 31,300
-
Net cash flow (900) (300) (3,300) 6,100 4,700 2,700
Opening balance 4,750 3,850 3,550 250 6,350 11,050
Closing balance 3,850 3,550 250 6,350 11,050 13,750

Notes to the cash budget:

 The opening balance of cash at the start of January is taken from the balance sheet's cash at

bank figure. The closing balance will then appear on the budgeted balance sheet as at 30
June.

 The receipts from debtors for January will be December's sales. This data is taken from the
Balance sheet as at 31 December - under the debtors figure.

 The payments to creditors for January will be found under the creditors figure on the balance
sheet as at 31 December.

 The sales and purchases figures for June will not appear in the cash budget as they are not

paid or received until July - which is outside the cash budget. However, they will appear as
debtors and creditors on the balance sheet as at 30 June.

 Depreciation is not a cash flow - and will not belong in any cash budget.

 Drawings appears in a cash budget but not in a budgeted profit and loss account.

The forecast set of final accounts will appear as follows:

M Gibb - forecast trading and profit and loss account for six months ended 30 June 2007

- £ £
Sales - 172,000
Less Cost of goods sold - -
Opening stock 5,500 -
Add Purchases 139,000 -
- 144,500 -
Less Closing stock 5,700 138,800
Gross profit - 33,200
Add Rent receivable - 800
Less Expenses - 34,000
Wages and salaries 14,400 -
Insurance 600 -
Overheads 1,800 -
Depreciation 1,200 18,000
Net profit - 16,000

The depreciation provision is based on the following:

£20,000 x 10% = £2,000 x 6 months = £1,000

£6,000 x 10% = £600 x 4 months = £200

Total depreciation = £1,200

M Gibb - forecast balance sheet as at 30 June 2007

- £ £ £
Fixed assets - - 50,000
Premises - - -
Equipment - 26,000 -
Less deprecation - 15,200 10,800
- - - 60,800
Current assets - - -
Stock 5,700 - -
Debtors 36,000 - -
Cash at bank 13,750 55,450 -
-
Current liabilities - - -
Creditors - 35,000 -
-
Working capital - - 30,450
-
Net assets - - 81,250
-
Financed by: - - -
Capital - - 68,250
Add net profit - - 16,000
- - - 84,250
Less Drawings - - 3,000
- - - 81,250
Note the following:

 Drawings only appear on the balance sheet and the cash budget but not the profit and loss
account.

The closing balance on the cash budget becomes the cash at bank figure on the balance sheet.
Exam tips - budgeting and budgetary control

 Make sure that you can construct the different types of budget based on the information given.

Cash budgets are by far the most likely ones to come up in any examination, but it is possible for
other types to appear.

 When drawing a cash budget, always remember that it is on a cash only basis - that means no

provisions (e.g. depreciation) and no accruals would need adjusting for. If you've just been

constructing a profit and loss account then it can be confusing having to switch from the accruals
concepts to the cash only idea in fairly quick succession. Be on your guard and avoid silly errors.

 If constructing a forecast set of final accounts, always remember to use the final cash figure in
your cash budget as the bank or cash balance.

 Look at all the information carefully - it will be used in some form.

 The construction of some budgets may not start at the beginning - it will help you to see the

construction of the budget as similar to a puzzle solving exercise where you can only put so much
information in initially and then add more in as the 'jigsaw' becomes clearer.

 The effect of budgeting on the organisation (possible and negative) will need to be considered as
well - learn the purposes of budgeting and why a firm would want to budget in the first place.

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