BUSINESS AND MANAGEMENT ACCOUNTING AND FINANCE

BUSINESS AND MANAGEMENT ACCOUNTING AND FINANCE Unit 3.4 Budgeting (Higher Level)

Content and Learning Outcomes Content! Types and purpose of budgets! Cash Flow Forecasts! Variance Analysis Learning Outcomes! Explain the importance of budgeting for organisations.! Prepare and analyse a Cash Flow forecast from given information.! Calculate and interpret variances

Reading Focus Stimpson. AS and A Level Business Studies, Chapter 30 Hall, Jones and Raffo. Business Studies, 3 rd Edition, Units 46,47&54 Barratt and Mottershead. AS and A Level Business Studies, Units Jewell. An Integrated Approach to Business Studies, 4 th Edition, Units 28 & 34

Types and Purpose of Budgets Context As businesses expand the need for control grows and becomes more difficult. A small business can be run informally. The owner is the manager, who will know everyone, be aware of what is going on and will make all decisions. In larger firms work and responsibility are delegated which makes informal control impractical. To improve control budgeting has been developed. This forces managers to be more accountable for their decisions. A budget is a quantitative expression of a plan of action prepared in advance of the period to which it relates. It must be a plan and not a forecast a forecast is a prediction of what might happen in the future, where as a budget is a planned outcome which the firm hopes to achieve. A budget will show the money needed for spending and how this might be financed. (Barratt and Mottershead) Budgets are based on the objectives of the business.

The Purpose of Budgets Essential Characteristics of Budgets They are prepared and agreed in advance. Cover a specific time period. They are expressed in either financial terms or in real terms (that is physical quantities). They relate either to the firm as a whole or to a part of it (such as the marketing department). Functions of Budgets To assist the planning process To communicate plans. To coordinate activities and ensure harmony between different parts of an organisation. Clarification of authority and responsibility. To motivate staff. To control and evaluate performance.

The Information Contained in a Budget Information contained in a budget may include any or a combination of the following: q Revenue q Sales q Expenses q Profit q Personnel q Cash q Capital These are referred to as Budget Factors. A budget can include any business variable which can be given a value

Types of Budgets Objective Budgets Flexible Budgets Capital Budgets Operating Budgets These are based on the best way of achieving particular objectives. They contain information on how a business will achieve these objectives. For example, a sales budget might show how a sales target will be met. These are designed to change a business changes. Changes in business conditions may result in very different outcomes than those budgeted for. A flexible budget takes these into account. For example, the sales budget could be altered if there is a sudden increase in demand resulting in much higher sales level. Plan the capital structure and the liquidity of the business over a long period of time. They are concerned with equity, liabilities, fixed and current assets and year-end cash balances. Plan the day to day use of resources. They are concerned with materials, labour, overheads, sales and cash

Approaches to budgeting Incremental Budgeting: This uses last year s budget as a basis and an adjustment is made for the coming year. One advantage to this type of budgeting is that using the previous year s budget figures as a basis means that each department does not have to justify its whole budget for the coming year only the change or increment. On the other hand, this type of budgeting does not allow for unforeseen events. Zero Bases Budgeting: This requires all departments and budget holders to justify their whole budget each year. The advantage of this type of budgeting is that it provide added incentives for managers to defend the work of their own section. Also changing situations can be reflected in very different budget levels each year. On the other hand, this type of budgeting can be time consuming, as fundamental review of the work and importance of each budget-holding section is needed each year.

The Budget Process External Factors What happened last year Organizational Objectives Forecasts of the future Key factor likely to be sales Sales budget: Production; Region; Departments Cash Budget Administration Budget Materials Budget Selling& Distribution Budget Coordination: This is essential Master Budget: Balance Sheet & Trading and Profit and Loss Account

The Budget Process Stage 1: The most important organizational objectives for the coming year are established. These will be based on: the previous year s performance; external changes likely to affect the organisation; forecasts based on research. Stage 2: Identify the key and limiting factor which is most likely to affect the organisation. In most businesses this is likely to be sales. Hence, the sales budget is the first to be prepared. Stage 3: The sales budget is prepared. Stage 4: The subsidiary budgets are prepared. These will include cash budgets; administration budgets; materials budget; selling and distribution budgets. Stage 5: The budgets are coordinated to ensure consistency. Stage 6: A master budget is prepared. This will contain the details of all the other budgets and conclude with a budgeted profit and loss account and balance sheet. Stage 7: The master budget is then presented to the board of directors for approval.

The Stages in Budgetary Control Process Preparation of plans Analysis of variances Comparison of plans with actual results

Variance Analysis What is a Variance? The difference between actual and standard occurrences. Variance Analysis: The analysis of performances by means of variances. Used to promote management action at the earliest possible stage. Variance = Actual Value Planned Value Purpose of variance analysis: To provide practical pointers to the cause of off-standard performance so that management can improve operation, increase efficiency, utilise resources more effectively and reduce costs.

Budgetary Control Variance Analysis A Variance in budgeting is the difference between the figure the business had budgeted for and the actual figure. Variances are calculated at the end of the budget period as this is when the actual figures will be known. These figures can be favourable (F) or adverse (A). Favorable variances occur when the actual figures are better than the budgeted figures. Budgeted ($) 25,000 (Revenue) 20,000 (Costs) Budgeted Sales Revenue and Costs for the month of August, 2006 Actual ($) Favourable Variance (F) 29,000 18,000 4,000 2,000 Adverse Variance (A) Adverse variances are when the actual figures are worse than the budgeted figures. Activity: Question # 4 Source: Unit 47, page 334, Hall, Jones& Raffo, Business Studies 3 rd Edition

Why is Variance Analysis an essential part of budgeting?! It measure the difference from the planned performance of each department.! It assist in analysing the cause of deviation from the budget.! The deviations from the original planned levels can be used to change future budgets in order to make them more accurate. For example, if sales revenue is lower than planned as a result of market resistance to higher prices, then this knowledge could be used to help prepare future budgets. Case Study: Maison JP et Chateau JP Source: Unit 47, page 334, Jones, Hall, Raffo, Business Studies 3 rd Edition

Profit Variance Total Cost Variance Total Sales Margin Variance Direct Material Variance Direct Labour Variance Overhead Variance Sales Margin Variance Sales Volume Variance Material Price Variance Material Usage Variance Wage Rate Variance Labour Efficiency Variance Exercise: Question # 1 Source: Unit 54, page 376, Jones, Hall, Raffo, Business Studies 3 rd Edition Types of variances

Variances Profit Variance: The difference between actual profit and planned profit. All other variance will affect the profit variance. Total Cost Variance: The difference between budgeted total cost and actual total cost. Direct Material Variance: The difference between budgeted direct material costs and actual material costs. Cost and Usage of flour for a biscuit manufacturer Price per Kilo ($) Usage (Kilos) Direct Material Cost ($) Budgeted Actual Direct Material Variance 1.50 1.30 2,000 2,200 3,000 2,860 140 (F) The favourable variance presented here is influenced by two other variances. Material Price Variance: Actual price of direct material is different from budgeted or standard price. Material Price Variance = (Budgeted Price Actual Price) * Actual Usage = ($ 1.50 - $ 1.30) * 2, 200 = 0.20 * 2,200 = $ 440 (F) 1.Why is the Material Price Variance Favourable? What are the possible factors which can account for Material Price Variances?

Variances Material Usage Variance: This is found by comparing the actual usage of material and the budgeted usage. Material Usage Variance = (Budgeted Usage Actual Usage) * Budgeted Price = ( 2,000 2,200) * $1.50 = - 200 * $ 1.50 = $ 300 (A) The material usage is adverse because the actual usage is greater than the budgeted usage. Material Usage Variance might arise because materials are: Wasted in production due to sloppy or careless work. Wasted because they are inferior. Wasted due to a machine malfunction. Used more efficiently because staff take more care in their work. Activity: Question #1& 2 Source: Unit 54, page 377, Hall, Raffo, Business Studies 3 rd Edition

Variances Direct Labour Variance: This will occur when the budgeted direct wage bill is different from the actual direct wage bill. Wage Rate Variances: This will result when there is a difference between the budgeted wage rate paid to workers and the actual wage rate paid. Budgeted and actual wage rates and labour hours for the biscuit manufacturer Budgeted Actual Direct Material Variance Wage Rate ($) 5.00 5.20 No. of Labour Hours 1,500 1,600 Direct Wage Bill($) 7,500 8,320 820 (A) Wage Rate Variance = (Budgeted Wage Rate Actual Wage Rate) * Actual Hours = ( $5.00 - $ 5.20) * 1,600 = - 0.20 * 1,600 = $ 320 (A) The wage rate variance is adverse because the actual wage rate is higher than the budgeted wage rate. The factors which might influence wage rates include: 1. Trade union pressure. 2. Shortage of skilled labour. 3. Government legislations such as raising the minimum wage.

Variances Labour Efficiency Variances: There will be a labour efficiency variance if there is a difference between the budgeted number of labour hours required in a budget period and the actual number of labour hours used. Labour Efficiency Variance = (Budgeted Labour Hours Actual Labour Hours) * Budgeted Wage Rate = ( 1,500 1,600) * $5.00 = - 100 * $5.00 = $500 (A) The Labour Efficiency Variance is adverse because the actual number of hours worked is greater than the budgeted number. The production manger may be responsible for this variance. The factors that might influence the number of labour hours used might include: 1. The productivity of workers. 2. The reliability of machinery used by workers. 3. How well trained workers are. Activity: Question 3 Source: Unit 54, page 378, Hall, Jones, Raffo, Business Studies 3 rd Edition.

Variances Overhead Variances: These arise when planned overhead costs are different from the actual overhead costs. Overheads are the general expenses incurred by a business. Overheads can be separated into fixed and variable overheads. Annual Budgeted and Actual overheads for the biscuit manufacturer Description Rent Rates Insurance Maintenance Distribution Telephone Administration Accounting Fees Depreciation Total Budgeted ($) 60,000 5,500 1,200 16,000 78,000 1,700 64,000 4,500 20,000 250, 900 Actual 60,000 5,500 1,300 15,000 85,000 1,600 62,000 4,700 20,000 255, 100 Question: What are the possible causes of Overhead Variances? Variance 0 0 100 (A) 1,000 (F) 7,000 (A) 100 (F) 2000 (F) 200 (A) 0 4, 200

variances Sales Margin Variances: A sales Margin Variance will arise if there is either a change from the budgeted volume of sales. Budgeted and actual prices and sales volume for cases of biscuits Budgeted Actual Sales Margin Variance Price Per Case ($) 2.50 2.60 Sales (Cases) 8,000 8,200 Sales Value ($) 20,000 21, 000 1, 320 (F) Sales Margin Price Variance: This will occur if the actual price charged by a business is different from the budgeted price. Sales Margin Price Variance = ( Actual Price Budgeted Price ) * Actual Sales = ( 2.60 2. 50) * 8, 200 = 0.10 * 8,200 = 820 (F) The Sales Margin Variance is favourable because the actual price charged is higher than the budgeted price. This variance may be the responsibility of the sales or marketing department. Question: What are some possible reasons for such variances in sales?

Variances Sales Volume Variance: This will occur if actual level of sales is different from the budgeted sales. For the biscuit manufacturer this is: Sales Volume Variance = (Actual Sales Budgeted Sales) * Budgeted Price ( 8,200 8000) * $2.50 = 200 * $ 2.50 = 500 (F) The Sales Volume Variance is favourable because the actual number of sales is greater than the budgeted number. Sales Volume Variance is likely to arise due to: Changes in the state of the economy. Competitors actions. Changes in consumer tastes. Government action, such as a cut in income tax. Changes in the quality of the product. Changes in marketing techniques. The Sales Margin Variance for the biscuit manufacturer is $ 1, 320 (F). It is influenced by both the Sales Price Margin Variance $ 820 (F), and Sales Volume Variance, $ 500 (F) Activity: Question # 4 Source: Unit 54, page 380, Hall, Jones Raffo, Business Studies 3 rd Edition.

Cash Variances Reminder: Cash and Profit are not the same thing. A cash budget is concerned with liquidity, not profitability. A cash Variance shows the difference between budgeted cash flow a and actual cash flow

Benefits of Variance Analysis It allows senior managers to monitor the performance of the organisation as a whole, as well as different sections of the organisation. Prompt variance analysis allows managers to assess whether variances re caused by internal or external factors. By identifying variances and their causes managers may b able to produce more accurate budgets in the future. This will aid planning and perhaps improve the performance of the business. Budgetary control in general helps improve accountability in the business. Cases: West Indian Carpets Ltd and Oasis Cookers Ltd Source: Unit 5, pages 466, Stimpson,AS and A Level Business Studies

Cash Flow Forecasting Why do businesses prepare cash flow forecasts Cash flow forecasts are drawn up to help control and monitor cash flow in the business. The following are some advantages of using statements to control cash flows. 1. Identifying the timing of cash shortages and surpluses. 2. Supporting applications for funding. 3. Enhancing the planning process. 4. Monitoring cash flow.

Cash Flow Forecast Cash Flow Forecast: This relates to the expected inflow and outflow of cash. Cash Flow Statement: This relates to the actual flow (in and out) of cash during the past time period. CASH Goods and services sold for cash Used to acquire resources Resources used to make goods and services The continuous Cash Flow into and out of the business

Why Cash flow is important to business ü Without sufficient cash flow businesses would not be able to pay its many creditors on time. The possible implications are: creditors may stop supplying goods or impose strict conditions such as cash on delivery ; discounts will be lost for prompt payments of bills; other traders will be less prepared to deal with the firm except on a cash basis. ü Wages and salary may not be paid on time and this will cause poor motivation; absenteeism; high labour turnover; and industrial unrest. ü New capital assets cannot be afforded and this can reduce business efficiency. ü Tax bills may not be paid

Cost of holding too much cash Loss of interest: Although there may be a token amount of interest earned on current accounts, it will be nowhere near the interest rate for long-term accounts. Loss of purchasing power: Unless the rate of interest is more than the rate of inflation, the money held in a bank account will actually lose its purchasing power. Opportunity Cost: Investors do not invest money in a business for the business to store it in a bank account. Investors expect a business to take well managed risks with their money; in the money is in a bank account, the business is possible risk averse and the investors may remove their investment. Question: What are the costs associated with a business holding too little cash?

Causes of cash flow problems p Overtrading p p p Holding too much stock High borrowing therefore high interest payments. Allowing too many goods to be bought on credit. p Businesses that rely on seasonal trade during the time that sales are very low, cash still needs to be spent on running the businesses. p High unemployment.

The Relationship between profit and cash Note: A profitable business may run out of cash, whilst the business recording a loss may have a cash surplus. How is this possible? The business may be selling more of its output on credit. Therefore a profit is being made as the goods are being recorded and sold, but the cash payment form customers will be received sometime in the future. This period of credit may leave the firm dangerously short of cash. The business may receive cash at the beginning of the trading year from sales made in the previous year. This would increase the cash balance but not affect profit. A business may buy resources from its suppliers and not pay for them until the next trading year. As a result the trading cost will not be the same as the cash paid out. When additional capital is introduced into the business this will increase the cash balance, but have no effect on profit. This is because capital is not treated as revenue in the Profit and Loss Account. The purchase of fixed assets will reduce cash balance but have no effect on the profit a company makes. This is because the purchase of an asset is not treated as an expense in the Profit and Loss Account. Sale of fixed assets will increase cash balances but have no effect on profit unless a profit or loss is made on the disposal of the asset. This is because profit from the sale of an asset is not included in the business turnover. Activity: Question # 4, Unit 46, page 327 Hall Jones and Raffo, Business Studies, 3 rd Edition.

Cash Flow Forecasting The receipts of the business represents the monthly income of cash. Payments are the outflows from the business. Some payments are often for the same regular amounts. Net Cash Flow for each month is found by subtracting total payments from total receipts. The opening balance in January will be the value of December s closing balance in the previous year. The closing balance for one month is found by adding or subtracting the net cash flow for the month for the opening balance.

Receipts Capital injection Sales revenue Total cash in Payments Capital Expenditure Labour Materials Total Payments Net Cash Flow Opening Balance The following cash-flow forecast is for Plants4U flower shop which is about to begin trading (all figures in $000s) July 10,000 2,000 12,000 15,000 2,000 3,000 2,000 ( 8,000) 0 Closing Balance (8,000) 1. Calculate the missing values X and Y. August 4,000 4,000 2,000 3,000 4,000 9,000 (5,000) (8,000) (13,000) September 8,000 8,000 2,000 4,000 4,000 10,000 (20,000) (13,000) (15,000) 2. State two ways in which the business might be able to improve its forecasted cash flow. 3. Complete the table for December based on the following forecasts Sales revenue raises by 10% from November. Capital expenditure is double the November level. Labour and material costs increase by 25% October 12,000 12,000 2,000 6,000 4,000 12,000 0 (15,000) (15,000) November 16,000 16,000 4,000 6,000 4,000 14,000 X (15,000) Y

Example of Cash Flow Statement

Managing Cash Flow Managing the floe of cash in and out of the business is one of the most important tasks of management. In order to do this effectively managers will need to assess: The likely timing of cash flow in d out of the business. This will largely depend on how long debtors take to pay their bills. The size and likely timing of payments out of the business; this will largely depend on the costs of the business and period of credit offered by the suppliers. Whether there are sources of finance to cover periods when cash shortage could rise. Time is of great significance to cash flow management

Dealing with Cash-Flow Problems q Reduce or delay expenditure q Obtain cheaper supplies q Rent or lease equipment rather than buying it outright q Delay the payment of bills extending the credit period q Get cash in more quickly from the sale of goods q Use debt factor to release cash from debts q Obtain overdrafts or short term loans Question: What are the advantages and disadvantages associated with these methods of dealing with cash flow problems? Handout: Methods of improving Cash Flow, Advantages and Drawbacks

Case Studies Westview Caravans Source: Unit 46, page 329, Jones, Hall, Raffo, Business Studies 3 rd Edition Tourist Trinkets Limited Source: Unit 5, pages 461-467, Stimpson,AS and A Level Business Studies Setting up in Business Source: Unit 5, pages 461, Stimpson,AS and A Level Business Studies Windrush Training Services Source: Unit 54, page 380, Jones, Hall, Raffo, Business Studies 3 rd Edition

BIBLIOGRAPHY 1.Barratt Michael and Mottershead Andy. AS and A Level Business Studies, Pearson Education Ltd,2000. 2.Jewell Bruce. An Integrated Approach to Business Studies, 4 th Edition, Pearson Education Ltd 2000. 3. Hall Dave, Jones Rob, Raffo Carlo. Business Studies, 3 rd Edition, Causeway Press Ltd, 2004. 4. Stimpson Peter. AS and A Level Business Studies, Cambridge University Press, 2000. www.bized.ac.uk WWW.NetMBA.com