Managing Finance and Budgets

1
Managing Finance and Budgets

• Lecture 9
• Budgets (1)

2
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

3
Key Concepts

• Budget definitions and purpose
• The budget-setting process
• Types of budget

4
Section A

• What are Budgets?

5
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)

6
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.

7
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.

8
Example of a Cash Budget
This example budget shows how we set targets,
allocate money, make predictions and set targets.

• 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

9
Example of a Cash Budget
These are predictions about the cash inflow .
These will become monthly targets for sales and
for debt collection.

• 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

10
Example of a Cash Budget
These are predictions about the cash outflow .
Most of these are fixed and will be paid at the
times stated.

• 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

11
Example of a Cash Budget
This is our predicted monthly cash
inflow/outflow. We can use this to detect peaks
and troughs

• 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

12
Example of a Cash Budget
Finally we can monitor the cash balance on a
month by month basis. We can predict for example
where overdrafts are needed.

• 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

13
The uses of budgets
14
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.

15
Section B

• How are Budgets Created?

16
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.

17
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.

18
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
19
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

20
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.

21
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

22
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

23
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.

24
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

25
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

26
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.

27
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.

28
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.

29
The Planning Control Process a summary
Mission, Aims, Objectives Market, Products,
Services Sales, Costs, Profits, Returns
1. Identify key objectives
Limiting factors External internal
Environment - market size, production capability,
competition
2. Identify available options
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 à Master budget
5.Collect information and control
Identify variances and respond as appropriate
30
Activity One

• List the advantages and disadvantages of
  using budgets in an organisation.

31
Activity One - solution

• Advantages
• Each are of the business knows exactly what they
  need to achieve
• Each manager knows precisely what resources are
  available to work with
• The business can plan effectively for expansion
  and be proactive, not reactive.
• .

• Disadvantages
• Targets tend to be met, but not exceeded
• Resources tend to be used up, even where they
  are not required.
• The business finds it hard to respond to new
  initiatives, since the resources are already set.

32
Section C

• What are the different types of Budget?

33
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.)

34
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.

35
Types of budget

• Cash budget
• Stock budget
• Debtors budget
• Creditors budget
• Income Expenditure budget
• Capital budget
• Discretionary budget
• Master budget

36
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

37
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

38
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

39
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

40
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
41
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.

42
Steps in a complex budget setting process
Establish responsibility for the budget-setting
process
Communicate budget guidelines to relevant managers
Prepare the budget for the area of the limiting
factor
Identify the key or limiting factor
Review and co-ordinate budgets
Prepare draft budgets for all other areas
Communicate the budgets to all interested parties
Prepare the master budgets
Monitor actual performance relative to the budget
43
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.

44
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.

45
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