Chapter 9

Budgeting

©2020 John Wiley & Sons Australia Ltd

 Learning objectives

After studying this presentation, you should be able to:

9.1understand the importance of planning and
budgeting
9.2explain what a budget is and describe the key steps
in the budgeting process
9.3explain the different types of budgets
9.4outline the components of a master budget and
prepare a master budget
 Learning objectives

9.5prepare a schedule of receipts from accounts receivabl

and a cash budget
9.6explain the use of budgeting in planning and control
9.7discuss the issues associated with the behavioural aspec
of budgeting.
 Strategic planning and budgeting

• Strategic planning concerns longer term planning

(typically, 3–5 years).
• It is usually carried out by senior management.
• It commonly relates to broader issues such as business
takeovers, expansion plans, deletion of business
segments and radical product/service development.
 Strategic planning and budgeting

• Budgeting is a process that focuses on the short term,

commonly one year, and results in the production of
budgets that set the financial framework for that period.
• Budgets operationalise strategic plans and allow
operational areas to understand how their area
contributes to the entity’s strategic objectives.
Strategic planning and budgeting
 Budgets

• Entities engage in a planning process that requires

involvement in a budgeting process.
• Part of the formal planning process relates to an entity’s
operational plans, including short term goals and
targets.
• Performance management involves setting targets in
other than just financial terms (e.g. improving customer
service, corporate governance, management techniques
and human resource management).
 Budgets

• A budget is the quantitative expression of an entity’s

plans.
• Budgeting can assist in decision making by:
– putting into operation longer term plans
– assessing the feasibility of strategic plans
– setting targets for managers
– identifying resource constraints in budget period
– identifying periods of expected cash shortages and
excess cash holdings
– assisting with short-term planning decisions
 Budgets

– providing profit forecasts and other financial data to

the capital markets
– forecasting data such as sales or fees, which commonly
set the level of activity for the budget period
– helping determine required inventory levels and
purchasing requirements for raw materials
– planning labour and other inputs
– determining the ability of the entity to meet financing
commitments.
 The budgeting process

• The budgeting process is a process involving evaluating

past performance, assessing and incorporating
expectations, preparing estimates, and monitoring and
adjusting budgets as required by changing circumstances.
• Involves a series of steps.
 Steps in the budgeting process

1. Consideration of past performance

2. Assessment of expected trading and operating conditions
3. Preparation of initial budget estimates
4. Adjustment to estimates based on communication with,
and feedback from, managers
5. Preparation of budgeted reports and sub-budgets
6. Monitoring of actual performance against the budget
over the budget period
7. Making any necessary adjustments to the budget during
the budget period.
 The budgeting process

• Throughout the process, communication with managers

who are affected by the budgets should occur.
• Simons (2000) highlights the need for those within the
entity to work together to develop the profit plan for the
coming year.
• The interaction of the various personnel enables them to
understand the impact of their decisions and to assess
whether value is created for the entity.
 Types of budgets

• Sales (or fees) budget — sets expected levels of activity.

• Operating (expenses) budget — often departmental
expense budgets.
• Production and inventory budgets (for manufacturing
entities) — for planning production levels and managing
inventory levels; often include sub-budgets relating to
direct materials, direct labour and indirect costs etc.
• Purchases budget — sets the required purchases of
inventory or direct materials based on sales budget (and
possibly the production/inventory budgets).
 Types of budgets

• Manufacturing overhead budget — focuses on

estimating overheads or expenses associated with
production activities.
• Budgeted statement of profit or loss — an aggregation
of the other sub-budgets such as sales budget and
operating expenses budget.
• Cash budget — a statement of expected future cash
receipts and cash payments.
• Budgeted statement of financial position — assets and
liabilities at end of period.
 Types of budgets

• Capital budget — focuses on expenditure relating to

long-term investments.
• Program budget — a budget form commonly used in the
government and not-for-profit sector, where the focus is
on costs associated with a specific program.
Applicable budgets for sample entities
 Master budget

• A master budget is a set of interrelated budgets for a

future period which provides a framework for viewing
relevant budgets of an entity.
• To enable the budget to be used as a control tool to
monitor the entity’s achievement of its plans,
classification of items included in the master budget
needs to mirror the entity’s chart of accounts.
• The chart of accounts is a detailed listing/index that
guides how transactions will be classified and recorded
in the financial reporting system.
 Master budget

• Because budgets are based on forecasts about the future,

complete accuracy is impossible and variances will
inevitably arise.
• A variance is the difference between actual and budget
results, and it can be either favourable or unfavourable.
• A favourable variance occurs when actual revenues are
larger than budgeted, or actual costs are lower than
budgeted.
• Conversely, an unfavourable variance arises when actual
revenues are lower than budgeted, or actual costs are
greater than budgeted.
Master budget
 Master budget

• The preparation of an operating budget for a service

entity requires market analysis to identify customers’
demand.
• This will lead to the preparation of the sales budget
detailing the estimated revenue that will be generated
based on forecast demand.
 Master budget

• Preparation of an operating budget for a manufacturing

entity involves:
– developing the sales budget
– developing the production budget
– developing the materials budget
– developing the labour budget
– developing the production overhead budget and the
selling and administrative expense budget.
 The cash budget

• The cash budget is a statement of expected future cash

receipts and payments.
• The cash budget assists decision making by:
– documenting timing of all cash receipts and payments
– helping to identify periods of expected cash shortages
and surpluses
– identifying suitable times for purchase of non-current
assets
 The cash budget

• The cash budget assists decision making by:

– assisting with planning and use of borrowed funds
– providing a framework for ‘what if’ analysis.
• For an entity that provides goods or services on credit,
one of the main tasks in the preparation of a cash
budget is calculating the cash receipts from the credit
sales or fees generated.
• This is commonly shown in a schedule of receipts from
debtors/accounts receivable.
Prepare a schedule of receipts from accounts
receivable and other sub-budgets
Prepare the cash budget
 Budgets: planning and control

• The preparation of the cash budget is an important part

of the planning process.
• It can then be used for monitoring cash performance,
also known as the control process.
• A cash budget prepared on a month-by-month basis is
much more useful for this purpose than one prepared on
a quarterly or yearly basis.
• As each month passes, the actual cash numbers can be
compared to the budget numbers. The difference
between the two is called a variance.
Variance report (example)
 Improving cash flow

• Cash inflow may be increased by:

– improving the collections of cash from debtors
– seeking ways to improve sales or fees
– reducing unnecessary stock levels
– arranging external finance
– providing an extra capital contribution from the
owners, or considering a change in ownership
structure
– selling excess non-current assets.
 Improving cash flow

• Cash outflow may be reduced by:

– cutting expenses by identifying areas of waste,
duplication or inefficiency
– making use of creditors’ terms
– keeping inventory levels to only what is required, as
excess inventory ties up cash and often adds to
storage and handling costs
– deferring capital expenditures
– reducing carbon footprint.
 Behavioural aspects of budgeting

• The behavioural aspect of budgeting and planning seeks

to explore two key areas:
1. relates to the ‘style’ of budgeting process used by
the organisation, such as the extent of participation
by managers in the annual budget process
2. relates to the impact of the budget targets and
plans on the behaviour, motivation and decision
making of the manager.
 Styles of budgeting

– In an authoritarian style of budgeting:

• senior management simply sets the targets and the
budget for unit managers
• unit managers have little say in the targets that are
set.
 Styles of budgeting

– In a participative style of budgeting:

• targets and budgets are arrived at by a process of
discussion and negotiation between senior
management and unit managers
• unit managers are seen to have had a say in the
setting of targets and the budget.
 Effect of budget targets on behaviour

• How motivated a manager might be regarding budget

targets is influenced by a range of factors, including:
– budget targets are best set as challenging but
attainable
– whether the manager feels ‘ownership’ of the target
– whether the manager is able to control the factors
influencing the achievement of the budget target
– whether the budget estimates provide too little scope
for managers to properly execute their duties.
 Summary

• Strategic planning influences shorter term aspects of the

budgetary planning process.
• A master budget may be viewed as a set of interrelated
budgets for a future period.
• A master budget is commonly classified into a set of
operating budgets and financial budgets.
• The behavioural aspects of budgeting relate to the
human involvement in decision making.